There are many investing strategies used in the stock market with the attempts of making extra-ordinary return. There is technical analysis (TA), and there is fundamental analysis (FA). Within TA and FA, there are also numerous ways to invest. TA has numerous indicators for buying and selling signals. FA practitioners use various investing strategies such as earnings and cash flows based, asset based etc. In valuations in FA, there are also numerous ways to carry out.

Here, I will introduce (again) an investing strategy which has been propagated by a local super investor; the 5-yardsticks of Cole Eye. This is a powerful value investing strategy propagated by, you guess it right, by Cold Eye, or Mr. Fong Si Ling.

Mr Fong has written many articles, notably the in the business sections of Chinese Newspapers Nanyang Siang Pau. He has given many investment talks, usually with full house attendance up to a thousand audients. He has published three investment books in Mandarin, which were selling like hot cakes in the bookstores. For those serious investors who wish to earn extra-ordinary return from the stock market, and know how to read Chinese, you should look for the books and learn from them.

The Five Principles of Cold Eye

In one of his presentations given to the public on 16^th March 2013, Mr Fong listed his 5 important considerations in investing. Here we call it the 5 yardsticks of Cold Eye. They are:

1. Return on equity, ROE,

2. Cash flows

3. PE ratio

4. Dividend yield and

5. Net tangible asset backing per share, NTA, which was changed to

6. Growth

The first 2 metrics are related to the quality of the business, while the later 3 are related to valuations, as compared to the price of the stock.

In a latest presentation and through his books, Mr. Fong has mentioned that he has discarded the NTA consideration and replaced it with growth, which he places higher emphasis among the 5 consideration.

Unlike the Magic Formula of Joel Greenblatt, which is my favorite investing strategy and requires deeper understanding of finance and accounting in terms like return on invested capital and enterprise value and their tedious computations, the 5 Yardsticks of Cold Eye is much user friendly. One needs not do much work and will able to compute these 5 metrics easily from the financial statements. All he needs to do is to pluck the right figures.

Here, I will give my thoughts on the 5 yardsticks of Cold Eye. I will use a stock which I have ben investing for a long time, Magni-Tech, based on its latest financial statements as on 30 April 2019 to illustrate.

1. Return on Equity (ROE)

ROE stands for Return on Equity. Return is the profit earned for a business, or net profit, the bottom-line in the Income Statement. Equity is the net worth of the company, or the book value.

ROE = Net profit / Equity

In Magni’s case, ROE = 20.6%

If you invest RM1m in a business, you would want to have a reasonable return from your capital, or equity you put in. A business is risky and probably you may want a minimum return of say RM250k, or 25%. For investing in the share market, you may want a minimum return, say 10%, or 6% above the return you get from bank deposit. If the business only returns you 4%, why would you want to invest in it when you can get that rate from bank fixed deposit without having any worry at all?

Hence, the ROE of 20.6% from Magni is certainly excellent.

2.Cash Flows

Company may be making profit or earnings. But be reminded that earnings may not be translated to cash as customers do not pay up according to terms of payment, or just default on payment, or simply, earnings are not real. You would also expect that you don’t have to stock up a lot of inventories and finished goods which will tied up your capital. Otherwise you would have to put in more capital or borrow more money as working capitals even though you appear to make money.

The exception is that for a fast-growing company, it requires a lot of cash for its working capitals and capital expenses. Eventually, the company should have good cash flows when growth slowed.

I would expect the hard cash I can received from the core operations, termed net cash flows from operating activities (CFFO), must be about the earnings over the years or even more as the expense item on depreciation in the income statement is not a cash outflow. My business would also require capital expenses each year to keep it going so that I would earn more in the future. This I would need to buy more and replenish the equipment, buy or open more shops etc. It would be ideal if these expenses can be met with the cash I receive each year and not having to come up with more of my own money or borrow from bank. After that, I would be happy if there is still money left for me to draw out (as dividend), or the company can have extra money to invest in other lucrative business. This money available after all the Capital expenses is termed as free cash flow, or FCF. It is this FCF from which dividends are paid out by companies.

FCF = CFFO – Capital Expenses

As FCF is hard cash left after all expenses including capital expenses. I would be happy if the FCF is more than 5% of the revenue. FCF of more than 10% of revenue would be fantastic.

For Magni, referring to Table 1 below as extracted and computed from its financial statements over 5 years, there has been always positive CFFO every year, with average of RM57.3m a year, or 5.1% of revenue. There also has always been positive FCF every year, with average over the last 5 years of RM49.9m, or 33.5 sen per share.

Table 1 Cash flows of Magni

We can conclude that the cash flows of Magni is good.

3. Price-to-earnings ratio, PE Ratio

A good business as shown by high ROE and good cash flows may not be a good investment. It depends on if the price is right. If the above business makes a lot of money, say RM300k, or 30% a year, would you buy it if the asking price is RM10 million, or a PE of 33 (10000000/300000)? This will only give you an earnings yield (1/PE ratio) of only 3%. This yield is lower than bank fixed deposit, and it would take 33 years to recoup the capital invested. Why would I want to invest in a risky business with that meagre return, unless it has huge earnings growth potential in the future? Hence a good business does not mean it is a good investment if the price, as measured by PE ratio, is too high.

For Magni’s case, at a price of RM2.60, or RM6.93 before the recent corporate exercise at the time of writing, and an earnings per share of 57 sen in its latest annual result, the PE is 11. It is inexpensive, or even considered as cheap, considering its high ROE of 20.6%.

As an investor, I am willing to pay a price of no more than 15 times earnings for a normal growth company in a reasonably good business, preferably much lower than that, and may be up to a PE ratio of maximum 20 for a high growth company.

4.  Dividend Yield

How nice it would be if the business earns enough for me to draw down RM100k a year consistently. For my dividend yield would be 10% (100000/1000000), or 3 times that of FD rate of about 3%. Besides, my business may still be growing and would provide me with higher dividends in the future. Hence many investors looking for regular income emphasize on dividend yield. Dividends are the “real” return provided to investors as they are given out as cash, in oppose to the illusive earnings, or net profit. A dividend yield, DY, comparable to fixed deposit rate will be good.

Magni pays a total of 23 sen dividend for fiscal year ended 30 April 2018. At a price of RM6.93 at the time of writing, the dividend yield is 3.3%.

This dividend yield is more than one can get from placing his money in fixed deposit in banks, which is good. Moreover, the dividend has been increasing steadily from 13 sen 5 years ago.

5.  Net tangible asset

If at the end if I want to exit from my business, if the net tangible asset of my assets worth more than what I put in, or more, I can sell them and recoup my initial investment (Of course I can also sell my business based on earnings multiple). These assets must of course the more valuable the better, for example in hard cash, property and land etc., rather than some money which I have been arguing with the debtors whether they are going to pay me or not, or some plant and equipment and inventories which are outdated and can’t fetch much money in a fire sales, or a worthless “Goodwill”.

Hence NTA is important too and I generally won’t pay a price more than two times its NTA. In some businesses, example the service industry, technology companies and other light assets industries, there are valuable intangible assets such as their people, technology or brand names which are not reflected in the NTA, and hence are trading at high price-to-book value. But that doesn’t mean they are bad investments, as earnings and cash flows are more important.

In Magni, price to NTA is just about 2, not too bad.

6. Growth

A fast growth company will have its earnings increase at an accelerated pace. For example, if a company grows its earnings at 20% a year, using the rule of 72, its earnings will double in 3.6 years. If the stock of the company is selling at a fair price now based on present earnings, its share price will double in 3.6 years too, assuming it is selling at the same earnings multiple. In fact, the PE ratio of a high growth company may even expand and will sell at a much higher price. Hence this is the allure of investing in a fast-growing company.

One way to scout for a fast-growing company is to look at the capital expenses it uses each year in relation to the previous years. Referring Table 1 above, Magni’s capital expenses has been increasing for the last three years, and a jump in 2018 to RM12.5m. Its net income had increased sharply from RM52.2m to RM120m in 2017, and then dropped a little to RM103m in 2019.

However, the future growth, not the past, is the important consideration for investors. One may still can rely on the capital expenses in recent years to make an educated guess of the future.

The other consideration is to ensure the growth is quality growth which enhances shareholder value, rather than shareholder value destroying growth. This has been discussed in the previous chapter.

Summary

The Cold Eye yardsticks in investing appears to be an attractive investing strategy which can provide potential high return with limited downside. The metrics are easy to use and can be quite easily extracted from the three financial statements. Hence, anyone with a little knowledge of accounting would be able to carry out the exercise, and likely to earn extra-ordinary return over the long-term.

I have personally used this strategy successfully in Bursa, with my portfolio of stocks selected using the strategy beating many times the return of the broad index.

There are many other proven successful investing strategies one can use besides this. However, all require users to have the basic knowledge in accounting and finance, te language of business.

Do you wish to earn extra-ordinary return from the stock market using some proven investing strategies? Do you wish to acquire the necessary knowledge in accounting relevant to stock investing in order to evaluate a business, and some valuation techniques to see if the price offered is right?

If your answers are all yeses, you may contact me for a free eBook at,

ckc13invest@gmail.com

KC Chong