Who Are You, and What Is Your End Game?

“Tell me who your heroes are and I'll tell you how you'll turn out to be.” - Warren Buffett

(Side note: I ain't a huge fan of the way Buffett invest, particularly of the version that runs Berkshire Hathaway. It is a large entity, employed ways and means which aren't accessible by the small guy. But I like him enough as a person and love reading about what he does during his Buffett Partnership years)

I met up with a good friend of mine recently and pondered about what our end game should be. I do have a vague idea: when I am much older and alone, I would be living within a small residence in the company of a couple of cats. 

This is a picture generated by the wonder that is Dall-E:

Pardon the number of cats. Not sure why Dall-E generated only one. There would be a British short hair and the fat cat that lives at the void deck of my block.

Most people desire wealth-- the question is, "Why?" and not "How much?" 

Money is useless per se if it could not be used to buy something. So ultimately, it is the something that we desire. It could be a car, a kind of life, tangible or not. Munger wants freedom-- the freedom from shackles of having to answer to someone.

 

So why the quote at the beginning of the post? I find that a person's idol tend to be quite telling of what that somebody is, or desire to be. 

That, is literally the result of Dall-E when I enter the terms "Walter Schloss picking up cigar butts"

Unless you are a value investing nut, the name Walter Schloss would mean nothing to you. His returns are consistently better than the market's, and his investment approach is simple enough for a person like myself. He has no desire to serve the rich and the famous, or most of all, himself. 

He has never gone to college; I had a offshore learning liberal arts degree which I never put into use. He believe in thrift and have no worldly desires that I could think of-- I think I have been so for my whole life (which explains why I wasn't that driven in many aspects of life). My friend told me that I am like a blank canvas.

It wasn't because I dislike nice things. I just don't feel the joy (rapture?) of using them. I conclude that the end game is to find joy, from something or somewhere. What is the most beautiful thing in the world?

***

When I was starting out, I suffered a hefty loss speculating in small pharma stock. Falling down repeatedly, I told myself that I need to change. I need a system that was not only simple, but could work even if I am marooned on an island. I could think independently and this system could work reliably. 

On reflection, I think it is fair that I probably only half way there.

My wish in investing is that I could look at major market corrections calmly and take advantage.

My memory have not been great but I do remember 2020-22 pretty clearly. The biggest winners came from health, tech and the company everyone knows-- Tesla. Disruption was such a buzz word. Everyone around me wants to talk about those companies. Dollar cost averaging was encouraged for big tech and Tesla. 

I wasn't a fan because of a few reasons:
a) Back of the envelope numbers indicate pretty high multiples.

b) They are huge companies and there isn't much runway to grow (law of large numbers)

c) Competition will eventually come into the picture

[A] is largely about market reversion to mean as well as appetite/mercy. The mood of the market decides how much multiple a company deserves. The same company that have a 50x multiple could be sold down to a 30x multiple when growth slowed, or stalled. That is already a 40% loss btw! 

However, if they could maintain their ROE consistently, the market will usually priced them many folds in the far future. But the big companies have the size disadvantage.

With [B], the David (which is you) will find yourself in the company of Goliaths, which are institutions and big players. They have a tremendous advantage over you as an investor. They might be more in tune with the industry, intimate access to insiders, news; clearer understanding of the interlinking macro-economics data and its interpretations... the list goes on.

With smaller companies, the big players are just not interested.

[C] comes to everyone and erodes return over time, unless you have a competitive advantage. Few companies possesses that. As of writing, Tesla had to cut prices in China. That says something.

Generally, the kind of person that you are, affect the kind of beliefs you have, and the way you would invest. I am deadly boring and pessimistic-realist. I know my approach would bore people to death, but I know I can lose very little (most of the time), because I don't swing for the fences.

I have associates that seeks a more directly-rewarding approach such as  looking for catalysts or likely improvement in earnings. Another approach is to look at macro economic and anticipate which industries would enjoy tailwinds. I have doubts that these approaches work very well in the long term, but I know one thing very well-- and that these approaches are too tough for me and I should avoid them.

In short, it isn't that these approaches don't work. They are too tough for me.

I have to accept that I could not enjoy the fruits that these people could have, but I avoid the pains as well. 

My simpler approach will work fine in most years. There won't be a crowd cheering me on when I finish the race. Neither is anyone going to pat my back, nor do I have to call people dumb or donkeys to constantly validate myself (or derive joy from putting others down?) and feel good. 

***

If investing is a cross country cycling race, and you knew that you do not have the kind of physique to go fast for a long time, or couldn't climb over obstructing mountains to save time, then you have to use other tactics. 

Perhaps you could sleep less and cycle at a moderate pace. 

Or perhaps you are a tough cookie-- you could choose to pedal on even during the foul weather, unlike everyone else who is seeking shelter.

If you are the only person left delivering food in this weather, I guarantee that you will not run out of orders.

Investing is like that. You don't have to act in a manner that disadvantages you. Don't play games you can't play.

Be realistic of the expected returns with the kind of strategy you employed. You could 10x a stock in 1 year, doing something really stupid but you could lose the same (or more!) with the same approach.

I knew long ago that I could never get rich fast.  I couldn't bring myself to take on risky paths like leveraging, buying tons of call options. I would love to get rich fast.

And it is very frustrating because I could see my parents ageing day by day and by the day I "finish" this race, they might no longer be around. I started too late.

And I do feel like I am a failure for that. For the young ones reading, you have my envy. You have a lot of options. Start early, fall down enough times, and you will learn to balance yourself very well.

Thank you for reading and I wish you good health.

Methods of Determining Value

The following outline the general methods in which I look for value in the market

1) Adjusted Book Value

As the term suggests, this is more than looking at the "shareholder's equity" value of the balance sheet, and taking into what the account that some assets are more reliable than others.

In a bullish market, an investment portfolio that consist of stocks in vogue (such as Perfect Medical's investment in tech stocks) should be adjusted downwards. Obviously you have to make a judgement call. Likewise, it might be prudent to be skeptical with property valuation which are based on level 3 inputs, or those based on a very low capitalization rate. More so, such valuation are less trustworthy if they were valued by the same company over an entire decade.

(cap rate = rental / property valuation; hence if rental does not change over the years, this would suggest that valuation has gone up, which can be unreliable). 

Good will will classically be adjusted downwards to zero by most geriatric investors (like myself). 

A note about non-interest bearing liabilities, such as payables. Always remember that account payables should be adequately covered by account receivables. Inventories should be revised aggressively downwards unless appreciation over time is possible (luxury watches, for e.g.). 

Look for an increasing net current assets throughout the years-- it is usually a sign of an attractive company.

This is, by far, my favourite.

2) Heavy Insider Buying

Between salaried employees and majority shareholders, I would certainly prefer that salaried employees be the ones buying stock, and that of reasonably large sums. I recalled before the ship sunk for Noble (the commodities trading company in Singapore), the owner was buying huge chunks of shares. Owners can be irrational.

Unfortunately, this could be the same case as one of my major holdings (Central China Real Estate Holdings), so I do feel uncomfortable writing this.

Company share buybacks are less convincing than directors buying stock out of their own pockets. Shares, from the former, could be willfully used for employee share option schemes, instead of cancellation.

3) Low PE adjusted for cyclicality

Within the category of  price to earnings, one could argue that Company A is trading lower than its peers in an industry group. This falls under what I call "relatively undervalued," which is one of my least favorite kind of valuation. For instance, company A could be selling at 20 times earnings and deem cheap, if most of its peers are selling at 40. Obviously 40 is high number, and 20 is not modest.

If you were to find companies that fit John Neff's criteria, in the area of neglected growth, that is even better. Neff have this beautiful simple formula which takes growth in earnings (as a percentage) + dividend and divide the sum by its PE. Comparing this with the index, it does reveal bargains. But I am not a fan of this approach and I do not use it as it is too complicated for me.

Generally I am not a fan of using earnings.

4) Troubled stocks selling at a low free cash flow multiple

This is one of my favourite categories-- of course not all companies could generate consistent cash flows. I use an average of multiple years of cash flow, against the market cap, as a gauge of bargain. Unfortunately, there is always some kind of trouble involving these companies, and holding them takes a lot of heart and patience.

(The following are what some call 'special situations')

5) Restructuring

A company consisting of different business segments may choose to rid itself of the underperforming ones. For instance, a company dealing with a loss-making student hostel accommodation, and a very profitable foreign worker lodging arm, could choose to sell off the student hostel business. This would result in better earnings in the end, and is likely to cause the share price to appreciate.

This is one way how a loss-making company could outperform a profitable one.

6) IPO/ Spin-offs

This does not refer to the typical IPO which happens very often when the market is frothy. I am referring to perhaps, company A, who has a huge chunk of stock in B, which is going public through the form of an IPO. 

Generally, an IPO underwriter try to serve two parties of interest-- the owner, which wants the price as high as possible; and itself, who wants to set a price modest enough so that price appreciation is possible. The latter is much less probable these days. 

Spin offs refer to companies who wish the list a subsidiary, by distributing shares to existing share holders of the parent. The main motivation of such an act is to reward management in the spin-off, or to improve the financial conditions of either the parent or the spin off. Sometimes a spin off could be used to highlight how undervalued the parent is, usually when view from a "sums of the part" perspective. 

7) Going Private Situations

When a company decides to de-list, it would usually have a reasonable amount of success by offering a respectable premium over its last transacted price, or book value.

By offering this premium, most existing shareholders will cash out so as to avoid the pain of watching the price fall back to pre-announcement levels. On the other hand, arbitrageurs, or parties acting in concert with management, would hold on and vote favorably to de-list.

On the flip side, when deals fall apart, and the price do fall back to pre-announcement levels, it might be wise to accumulate some shares. I have two reasons why this might be ideal: 1st, the pre-announcement price is likely reasonably modest, or else why would there be interest for a de-listing? 2nd, the interested party is likely to try again sometime in the future.

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There are other niche areas, such as distress investing, bond buying, price arbitraging; but these means are far too complicated for myself and hence not practiced.

Speculative Profits: What is Investing?

If you invest in stocks with the mindset that cash is king, here is a company that has generated next to no cash, but yet brought unbelievable amount of profits to shareholders as its stock price climbs on stairs made of purely hopes. This company is mm2Asia ("mm2").

Shareholders who bought right on day 1 have little to complain about. It closed at $0.25 a share and gone through two, 1-to-2 splits in 2016. Today the share price is $0.37, which is $1.48 a share. That is a 592% increase.

On paper (accounting profits), the business generate salivating numbers:

The company has the right to boast, on its annual report in 2018, that its CAGR for revenue grow 85.8%, and net profit 77.0%. It has acquired and spun off companies, and including a large, well-known cinema operator in Cathay. Yet it has paid no dividends to its shareholder, who probably won't complain on the account of its stock price (and free entertainment tickets via balloting).

To me, if you were to insist on paper profits, the right metric is not net profit but returns on invested capital. A revenue growth and a net income that grew side by side is common. But if the growth in paper profits is slower than the growth needed for capital, it is actually detrimental.

The simplest way to measure ROIC is to take net income and divide it by the total of shareholder equity (without accounting for minority interest), and debt. ROIC calculation can be extremely subjective since the proper way to do it is to take cash generating assets minus interest-paying liabilities. What I am doing here is the blunt and lazy way.

Shareholder equity does not include minority shareholder's capital.

All debts include non-current and current debt.

From 2015 (first year since IPO)  to 2018, the share capital injected into the company is about 100m more. Returns on capital has been great in 2015, 26.09%. Today, the figure is a lot more modest at 10.81%. 

What about the cash?

 

If one were to take into account Operating Cash Flow (OCF) before working capital changes, this company is actually pretty good. But its net operating cash flow has been next to nothing. It is no surprise that the company is in a hurry to spun off subsidiaries in public listings (which will generate the highest pay off), paid zero dividends in the last 4 years, and had to acquire a large sum of debt to acquire Cathay.

I note that they have a severe increase in payables, from 46m to 274m this year. It is a sign of potential cash flow issues.

Investors in mm2 are still paying about 16 price to earnings, based on trailing twelve months basis.
The price is far from being depressed, despite a significant decline of 47% from this year's high.

But who cares right? 592% in paper profits for investors!

***

Just to illustrate how little do investors consider stocks as a form of business ownership, consider the story of TheHourGlass. It is far from being the most neglected company in SGX, listed for more than 20 years. Neither is this company the most profitable...

Based on figures since 2008, the company has never had a negative cash flow. It has an average of about 29m in free cash flow yearly, since 2008-2018. By the wisdom of the market, the whole company is worth 472m. This represent a cash yield of 6.1% as a business owner. As a minority shareholder, dividends were paid for the last 10 years, with a yield of about 3% currently.

For ten years, next to no additional share capital was injected in its books. This means there were no significant shareholder dilution.

Yet the price of this company move between $0.56 to $0.67 a share for the last 5 years.

***

So what is investing? It might be old fashion to think that stocks represents business ownership, as the market constantly ignore the essence of capitalism which is to generate cash profits, but chose to focus on potential instead.

I guess the market loves risk takers.

Is it easier, as an investor, to bet on the future of a company that has presently no cash generating abilities, or to bet on a consistent cash-generating company that is in some kind of temporary trouble?

I am a sucker for the latter.

Prospecting from the "Dustbin"

One popular way of searching for value is to sleeve through the "dustbin"... namely the 52-weeks low stocks.

I have such a readily made screener in www.stocks.cafe. Parameters used are illustrated below:

I would explain some of the terms above for users unfamiliar to the stocks.cafe platform. "Close% from 52-weeks Low" is expressed as a percentage. Any stock's last closing price that is within 3% from the lowest in the last 52 weeks will appears in the results.

"Price/ Tangible Book" refers to the closing price divided by the book value, minus any "soft" items like goodwill, land rights, etc. It isn't that they do not have value... it is just hard to determine. The prudent value investors tend to ascribe a value of 0 to it. Now I will say this screener might not work too well on this, so you need to double check the annual reports for the prospect. I don't have any hard and fast rules about book value, but anything within 3 or so is still reasonable. I intend to write  another post regarding the book value investing approach later.

Debt/Equity is expressed as a number. If the figure is 0.3, it means that for every 1 dollar of assets, there is 30 cents worth of debt. Ideally this should be interest-bearing debt-- trade payables are usually not interest-bearing and should not be accounted as debt.

"Last Close > 0.1" is a personal choice-- I do not want to look at any penny stocks in SGX. These stocks are prompt to consolidation in the future. For the uninitiated, SGX has this weird rule that stock prices must meet the Minimum Trading Price of > 0.20 in X amount of years; stocks are traded in 100 units minimum in Singapore.

Since my capital is small, I will gladly forfeit some quality penny stocks.

EV/ EBIT_operating_income > 0 is a funny one. It basically means Enterprise Value (EV), which is Market Cap (all stocks multiply by market price) + Debt - Cash.

There are a couple of ways this can be negative. First, the company might have more cash than debt and market cap combined. These are the ultimate value stocks. Since I forced the screener for give me a positive value, this means I would miss such stocks. There is nothing to stop me from creating another screener to look for these value stocks The other reason why it will be a negative number, is that EBIT is negative (company is making a loss).

EBIT_operating_income is not a choice I preferred, but the only one that is available. For the uninitiated, this refers to profit that is available after all costs, except tax and finance cost (which is interest charges from borrowing), is levied. The whole idea is to evaluate companies from an equal footing.

Current Yield > 0 is the current dividend yield in percentage. A dividend must be present. You will need to wait for dustbin stocks to recover and I want to be paid for it.

***

 Running this screener for just SGX this week, I have the following:

The data is copied and pasted into Microsoft Excel for easier viewing. I added a column call Price/FCF. A company which has unsteady cash flows will have a very high or low number... this is just for my viewing pleasure.

The next step is to cut away all stocks that:
Do not offer a dividend consistently for years. Capitaland has been offering increasing dividends over the years, which is delightful.

Large debts; a very high D/E (debt/equity) number-- unless this is a relatively big company. As silly as this sounds, banks do give institutions a bigger leeway. For the smaller companies, they are removed. This is not to say that they aren't good stocks-- I just want to sleep better at night.

The next step is to look at each and individual companies from stocks.cafe. There is an advantage here presented by Stock.Cafe, an extract of the Profile tab of YZJ Shipbuilding as follows:

First of all, the book value must improve over the years. Book value has increased 0.698 to 1.389. Whether this book value is reliable... let's just say we will check that later.

More of an interest to me is the earnings, and free cash flow per share diluted. I want to see positive numbers in free cash flows. Most companies are capital intensive, which means for every dollar earned, a large amount of it is re-invested into the company for both maintenance and growth.

I want to say something about growth-- a growth in earnings per share is not necessary a sign of growth. It is merely a hint of growth, and the company's ROIC should be investigated. An EPS growth of 10% that results from a substantial increase in invested capital is not growth. 

I have digressed-- let's get back to screening stocks.

Companies that have less than desired reputation are also removed.The net result is 7 companies for further investigation, out of a starting of 26. This is just the first step. I would not be surprised if none of them make the cut at the end of the day.

If you do dustbin-picking very frequently, you will recognize names that appear time and again. Reputed value investors (like John Neff) advocate paying more attention to new stocks that appear in the list. My personal opinion is that the market is usually efficient-- so long term, they can't be that wrong.