Investment Process

An investment process is a SOP that you follow when you want to invest in a stock. For the sake of many non-Singaporean guys and Singaporean gals who have never bother to find out what their boyfriends did in the most unproductive 2.5 yrs of their lives. SOP stands for Standard Operating Procedure: a set of strict execution procedure to follow, during NS.

Anyways, SOP for investing is pretty simple, for me. You should modify your own investment process to suit your style. Investing is as much about your personal style as making money. Your investment process should help to drive your investment philosophy. The process I follow is summarized below

1) Screening
2) Fundamental analysis
3) Valuation
4) Technical
5) Monitor

Screening is the most tedious part of the whole process. Usually it takes a long time to come up with stock ideas if you do not have the relevant tools. Professional fund managers use screening tools to "screen" stocks that fulfill certain criteria. This would be like low PER, high earnings growth, high ROE etc.

Fundamental analysis is what a main part of this blog has been talking about. Things like financial statements analysis, financial ratios, SWOT analysis, intrinsic value etc. The company that you want to invest in must first pass the screening, and then you look in-depth into the company. This is the part when you see the company under the microscope. Scrutinize everything.

If everything looks ok up till now, look at valuations from all angles, PER, PBR, EV/EBITDA etc. A good company must be cheap. If it is expensive, there is no value to be gained by buying. See this post.

Technicals: buy when the timing is right. The general market is on a positive trend, but not too bullish. No analysts are looking to downgrade the stock. i.e. most of them have SELL or NEUTRAL ratings. Charts look ok. Overall sentiment is good but not overly optimistic. Of course, true value investors do not look at this because over time, prices correct themselves and move towards its intrinsic value. But a stock can still drop 10% 2 days after you bought them. If you don't like to stomach this kind of shock, better take a look at technicals.

And finally, when you have bought a stock. Monitor it. Not by looking at its daily price. But by looking at its business. Make sure they are making money, doing the right thing. If things are not going as expected. Sell.

Investing in a stock should be viewed very much like buying an house or a car. The more homework you do, the less likely get conned or lose money.

Secular trends

Our world is defined by huge trends or secular trends that last for some time, usually 5-10 years. In the 60s and 70s we have autocars, 80s we have Japan Inc, and the beginning of the 20yr US bull market. 90s was IT and Tech, Media, Telecoms (Ouch!), and now China and commodities.

Note: more often than not, the trend goes into bubble mode and the Greater Fool Game begins. It it important to know the difference and decide for yourself if participating in the Greater Fool Game is what you want.

Betting on these trends will reap you rewards far bigger than day-trading or any other money-making scheme you can ever think of.


Anyways, identifying such trends require good grasp of global condition and some innovative thinking. This I would say 99.99% of the brokers and their analysts lack. For a good reason. If you identify a trend, you need not buy and sell all the time. Just ride with trend until the cows come home. And this is not good for the brokerage business.

So what are the trends going forward?

1) Silver market: The world is aging rapidly as the baby boomers retire, cash in their pension money or CPF, they will need to find ways to spend it. In most other countries, they spend in on travel, buying houses, cars, buying LCD TVs etc. Hence the global boom in real estate, LCD TVs and autos.

2) China consumer market: Let's face it, The 21st century belongs to China. We have probably only been through 1/3 of the big China story. So far they simply built 10,000 factories but the Chinese consumers haven't even started spending yet. When they do, it will be interesting.

If you think about it, in the past 5 yrs, every big secular trend was actually due to China. Why did commodities go up? Why did steel prices tripled? Why did oil price shoot through the roof? Why can Walmart conquer the world with its cheap stuff? China. China. China.


Although the whole world has been talking about China for the past 10 yrs, we are probably not finished yet. China is probably Singapore in the early 80s. We have more to go.

Of course, there will be other secular trends. They will be up to us to find out. It will probably be difficult. But when you do, pls update this blog.

Earnings yield

Earnings yield is the reciprocal of the Price Earnings Ratio or P/E Ratio or PER.

Hence

P/E Ratio = Share price / Earnings per share (EPS)
Earnings yield = Earnings per share (EPS) / Share price

or

P/E Ratio = Mkt cap / Net Profit
Earnings yield = Net Profit / Market cap

If you still having problems, try reading a few related posts below.
1) Price Earnings Ratio
2) Market Cap
3) Net Profit

Ok, now that we know what is Earnings Yield, let's try to examine it further. Now if you think about it, Earnings Yield is actually the return that you can get by investing in this stock. Say if a stock has an Earnings Yield of 10%, it means that by investing $100 in the stock, you would get $110 back by the end of the year.

Now if you get this, cheaper P/E means higher return right? Because Earnings Yield of 10% would mean that the P/E of the stock is 10x. (10% = 0.1 and reciprocal of 0.1 = 10.) And P/E of 10x is damn bloody cheap because it means that the stock can give you 10% return p.a. and as we all know (hopefully) investment on average earns you 5-8% over the long run.

Consider NOL, which trades at P/E of 3x, it means that its earnings yield is 33%. Sounds like a screaming buy right? Actually, it is a huge debate right now, nobody knows the answer. This is because no one is sure that the P/E can remain at 3x, say 5 yrs from now. This means that some players in the market think that NOL may lose truckloads of money in the next 5 yrs. And he is not willing to buy it now, even if NOL is super cheap today.

As with intrinsic value and forward PER (i.e. P/E ratio in the future) guesswork is involved here. And the guesswork is the usually the one thing that determines whether you will lose truckloads of money or not. Well investing is not easy, I guess. Earnings yield is just another tool to try to make solving a 10 trillion step equation 1 step easier.

What the heck drives stock prices?

There are two answers that drive stock prices in the long run. By long run, I do not mean 24 hours, or 2 weeks, or 3 months or 2 years. Long run means 5 to 10 to 30 years. Yes, really really LONG RUN.

The answer is consistent earnings growth and valuations. If a company can consistently grow its earnings for the next 30 yrs, AND, further if current stock price has not factor that in, then the stock is a buy.

Now if you really think about it, how many co.s 30 yrs ago grew their earnings for 30 straight yrs? And if they did, wouldn't their earnings probably be like a gozillion times larger since it is compounded over 30 yrs. Well you are right and the answer is, maybe about 5 co.s, globally.

This illustrates how hard it is to find a good company and how harder it is to find one that actually trades below its intrinsic value. This is the truth. And this is value investing. But it is not impossible and the prove is Warren Buffett.

Now just for the fun of it, I have included a list of irrelevant stuff that will drive Wall Street crazy.

1) Quarterly earnings announcement
2) Recommendation change from sell-side analysts
3) Technical outbreaks on stock charts
4) Update on economic indicators
5) News on stocks like M&A, new product launch, CEO change, dividend increase, share buyback, alliance with competitors, entry into new businesses etc

EV/EBITDA

EV/EBITDA, pronounced as (EE-VEE-EE-BIT-DAH) tries to measure the cheapness of a stock. i.e. similar to other valuation metrics like PER or PBR.

EV stands for Enterprise Value which is the value of the entire firm to both shareholders and debtholders. Its formula is shown below:

EV = Market Cap + Net Debt
Market Cap = Read this post
Net Debt = Total Debt - Cash

And EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization. Whatever that means. Well for those really interested, read this post. For those really not interested, well let's just say EBITDA tries really hard to measure some kind of profit (not the kind most good old value investors would like).

So, in essence, EV/EBITDA tries to measure the intrinsic value or cheapness of a company, just like PER or PBR. But it looks at it from the perspective of both the shareholder and the debtor. (The other two ratios only look at it from the shareholder's perspective.)

On top (the numerator), it takes into account both market value (or market cap) of the company, and its debt. At the bottom (the denominator), it looks at profits before interest, tax and even depreciation. Well from this ratio's creator's point of view, this is profit attributable to both the shareholder and the debtholder.

So, there you have it, a new ingenious ratio. EV/EBITDA ranges from 5-25x nowadays with fair value usually at 10-15x.

Intrinsic Value - Part 2

Ok, we are back in the business of Part 2 and 2nd chances. This time round, we take a second look at intrinsic value.

Well, to recap, the intrinsic value of a stock or an investment is its true or inherent value based on some valuation method. For more on its concept, pls refer to my previous post on intrinsic value. In this post, I shall attempt to calculate the intrinsic value of some stock using PER and EPS. Now please understand this is like not possible but I shall attempt it anyway.

Anyway, the idea behind is actually quite simple. Basically you must first have an idea of what is the true PER of the stock, and what is its potential EPS, say 5 yrs down the road. Then you can multiply PER by EPS and get the intrinsic value or target price. (Yes this is the dreaded target price given by analysts, and yes, none of them ever got that right and most likely, yours truly here won't get it as well.)

For those still blur, don't worry, here's the formula

PER = Share price / Earnings per share (EPS)

if we swap the formula around,

Intrinsic value or target share price = true PER x potential EPS

Simple right?

So, how do we know what is the true PER of the stock? Usually by looking at the market and industry PER. So today, STI trades at 15x PER and the airlines in Asia trade at 20x on average. So we can assume that SIA should trade roughly around this range. Let's arbitrarily assume that the true PER for SIA is 17x.

Next we need to determine its potential EPS. SIA managed an EPS of $1 in 2005. So assuming that it can maintain this level, say 5 yrs later. We have its potential EPS at $1. So to get its intrinsic value (or target price), simply multiply 17 x 1 = $17. SIA should trade at $17. Today it is trading at $15.7. So is it a buy?

Well, the answer is no, because our calculations may be wrong. What if the true PER is 15x? Or what if the potential EPS is only 80c?. If you work if this new set of no.s, (15 x 0.8 = 12) SIA should trade at $12. So how? Suck thumb lor.

Intrinsic value is not just a single number, it has a range of probable values. It changes when we use different assumptions and nobody ever gets it right. That's where margin of safety comes in. For those not-so-familiar, pls read the post on margin of safety.

In a nutshell, if ever SIA trades at $3. Then it is definitely a buy, because no matter how you tweak the two no.s (PER or EPS), you can never get below $3. But SIA will never trade at $3 unless Sept 11 happens on Christmas and New Year in 5 major cities or something. In other words, it is damn bloody difficult to find stock that trades below its probable range of acceptable intrinsic values . This is the challenge and this is value investing.

SWOT Analysis

SWOT Analysis is a method developed to analyse an individual company through a framework. It is much loved by Wall Street and you can usually find it in the Initiation Reports of companies by Wall Street analysts.

SWOT stands for Strengths, Weaknesses, Opportunities and Threats which is basically four aspects of looking at a certain company and see if it is worth investing. The words are probably self-explanatory but as an example, let's see how it works.

Strengths: Usually depicts the company's plus points, like having a high market share, or a competitive edge over its rivals, or the ability to raise prices despite public outcry, with the support from the Government

Weaknesses: The company's minuses, like high operating costs, weak product pipeline, poor branding, poor customer service, zero disclosure to shareholders and/or potential investors, labelled as an ugly duckling on Wall Street.

Opportunities: Events that will affect the company positively, like a new market for its products, or potential for the firm to be acquired, or the ability to acquire other smaller competitors, or Government support etc.

Threats: Things that will threaten the company's position. E.g. unfavourable regulatory changes, entry of a formidable new competitor, technological evolution that will render the co's product useless, consolidation between suppliers or clients etc.

So that's how SWOT does it. Systematically analyze four aspects and determine the company's position in each of them. Perhaps the takeaway behind SWOT is not just looking at the four aspects but more to analyse a company using a framework or system. This will help one to see the company is a better light, and hopefully make a better investment decision.

PS: Takeaway literally means "da bao" i.e. taking some good food/good babe back home or taking away an important lesson to be remembered.

Is investing a zero-sum game?

This is one question that I would like to answer a long time ago but have always thought I don't have a good answer yet. Nevertheless, I shall attempt to answer that today. Is investing a zero-sum game? I think the answer is both yes and no.

BTW, this post is talking about investing in general, which include fixed deposits, bonds, stocks etc, so not just stock alone, ok hor?

The answer is partly yes, it is a zero-sum game, because whatever you buy, you will have to sell to make a real profit (as in not just paper gain), and whoever bought it from you would be deprived from the amount that you profited. So whatever you gained, he would have "lost" (or failed to gain).

However, we must understand that the world's economy has been growing on average 3-5% p.a. for the past 100 yrs and stocks have grown at roughly 10% p.a. while bonds roughly 5% p.a. So in aggregate, investors would have earned roughly 5-8% (Hence this blog is called 8% p.a., in case you haven't realized), depending on their portfolio mix and also assuming that whatever they invested in did not go bankrupt or go into default. (Actually if they diversify, even if some investments become zero, others would have made up for it. So in aggregate their portfolios will still earn a positive return)

So this is to say, even when you sold your stock at a profit to the next guy, he will not necessarily lose money, because in aggregate, everything will grow, at the very least, with the world economy. He will at least earn 3-5%, if he simply buy government bonds, or 10% if he put everything into stocks.

In other words, the "zero" in the zero-sum is actually 3-5% (which is also roughly the global GDP growth rate) and for stocks, the zero is maybe 8-10%, depending which market you invest in. Hence the "no": as in investing is not a zero-sum game, if someone earns money, it does not mean that someone else is losing money.

To conclude, in the game of investing when you make a realized profit, you deprived someone of that profit but if the next person holds it long enough, he will not lose money, because at the very worse, his investment will grow at the same rate with global economy.

Straight line depreciation and crooked line depreciation

Depreciation is one concept that allows a lot of creative management to do a lot of creative accounting.

Just to mention a few popular tricks:

1) Increasing or reducing the depreciation life
2) Using crooked line depreciation
3) Depreciate things that are not supposed to be depreciable

Let's use the previous analogy of Ah Gou, the rogue taxi driver to see how each trick works.

In 1), Ah Gou decides that his taxi (which cost S$1000) can actually last 20 yrs, so assuming he still earns S$200, instead of booking only S$100 of profit, he can now book S$150 of profit, and the value of his taxi only drop to S$950 instead of S$900.

In 2), Ah Gou still depreciate over 10yrs, but he can depreciate the taxi less for the 1st few years, say, $80 for the 1st year, again he can book a higher profit of S$200 - S$80 = S$120. (In real life, usually company front-load depreciation so that subsequent years will look good, or so that they can sell their assets and book profits, like what SIA does with its planes)

In 3), say Ah Gou bought a phone for his personal use, but his clients got the no. and started calling him up to book his taxi. (Ok, mobile phones are not invented yet, but just an example ok?) He depreciate this cost of the phone (S$100) for 10yrs as well, so bcos of the phone, he earns more, say $250, but he only book the total depreciation of S$100 (car) + S$10 (phone) = S$110. And his profits increased to $140.

So as you can see, it is up to creative management and accountants what they want to do right? In the 3 examples, profits was easily increased by 20%-50% ($100->$120, $140, $150).

Fixed Asset and Depreciation

Fixed Asset refers are assets that are held by the company for its business operations and are not intended for sale and are held on for the long term. They include stuff like

1) Property, Plant and Equipment
2) Building and Structure
3) Furniture and Fixture
4) Land

Different industries will require different amount of fixed asset (heavy industries like automakers, or transportation sector like railway will need a lot of fixed asset but online co.s will require minimal fixed asset) but recently the general trend is for corporates to reduce fixed asset.

Fixed assets are usually depreciated over 10-30 years to determine its cost impact on the business operation. The value of the fixed asset is then reduced by the amount that was depreciated.

Ok, analogy time. Imagine in the 60s, when policemen still wear shorts, and anyone can buy a car and use it as a taxi, let's say that Ah Gou bought one such car for S$1000 and decided to be a rogue taxi driver for 10 yrs.

So after 1 yr, assuming straight line depreciation and assuming he earned $200 in 1 yr, he would have booked a profit of S$200-S$100 = S$100 of profit (assuming no other costs) and his taxi would be worth S$900.

And after 2 yrs, the taxi will be worth S$800 and by the tenth yr it will be zero. That's straight line depreciation, where the depreciation cost per yr is the same.

Asset Turnover

Asset Turnover is probably one of the most important ratios that Wall Street invented but ironically also the most overlooked.

Asset Turnover measures the revenue that can be generated by $1 of the firm's asset. i.e. how much money can be made from $1 of asset. It is calculated by dividing Sales over Total Assets.

To increase the firm's Asset Turnover while keeping Asset constant requires operational efficiency improvement. This cannot be done if the company is slack or has a lousy management.
This ratio also has some weight partly because both its components no.s are large no.s and large no.s are not easy to manipulate. (e.g. you can make your OP increase by 50% easily by pushing back some costs, but you cannot increase your sales 50% or decrease your assets 50% overnight.)

But this also means that comparison between different companies gets tricky. You get into situations when you try to compare Asset Turnover of Firm A at 1.0614x vs that of Firm B at 1.0615x. So which is better? You can't really say for sure, unless you are a Nobel Laureate for Applied Rocket Science for Not-So-Meaningful Financial Ratio Calculation.

Hence Asset Turnover may be useful only for historical comparison. If the Asset Turnover of a company has improved from 0.9x to 1.1x, you know that it has successfully generated more sales for every dollar of asset. This no an easy feat, especially if companies are already operating at full capacity. If they can increase Asset Turnover while at full capacity, it means that they somehow can make their existing facilities work harder (by streamlining processes or making existing pool of workers work harder etc) to generate the extra revenue.

However Asset Turnover cannot be used for companies that does not generate its revenue from tangible assets. (e.g. online businesses with no assets to speak of.) In such cases, we have no choice but to return to more popular measures like ROE or OP margin