September 2015

I had a nice chat with a fellow value investor in London who recorded his thoughts on the conversation, and kindly allowed me to reproduce it.

Lesson 4: “Mean Reversion”

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Prices, in long-term, will return to their mean. This is also John Bogle’s way of looking at the market from a general picture point of view. Moreover, mean reversion will help the investor to identify possible bubbles-wild fluctuations of prices that tend to sky-rocket and then plummet back to earth to reflect a number closer to the real value of the company.

This does not mean that markets are rational.

It means that in long-term, it is the business value that wins and not the short-term market vicissitudes.

Lesson 5: “Free cash flow”

As a new and enthusiastic value investment scholar, I read most of the books on Warren Buffett. Consequently, I heard of a concept called ‘owner’s earning’. Mathematically, this concept is translated into net reported income plus depreciation, amortization and depletion (DAD) charges minus capital expenditure (that is capital that the company needs to stay in business).

Mr. Buffett explained that he uses this measure instead of free cash flow (FCF) because FCF is measured as net income plus DAD charges. However, this is non-sense as one must also account for the costs of doing business. However,

I knew that the free cash flow was defined as cash flow from operating activities minus capital expenditure. Peter Lynch, one of Fidelity’s star managers and a legendary value investor, also uses FCF as operating cash flow less capex. Therefore, confusing hit my mind and I asked Jun Hao if he can clarify this for me. He suggested to use Peter’s Lynch measure for simplicity’s sake.

However, he strongly recommended to measure the FCF for a period of at least 5 years in order to get a sense of how a business is doing: remember free cash flow is the amount of money you as a business owner are left with at the end of the financial year – you cannot pay your bills or buy new business with reported net income but with cash only!

Lesson 6: “Enterprise Value”

Jun Hao suggests that a more accurate way of ascertain the market value of a business is to look at its enterprise value (EV) instead of looking at its market capitalization. Market capitalization is the result of number of shares outstanding times the share price.

However, EV is calculated by adding the net debt to the market capitalization and subtracting the cash and cash equivalents from that number. EV is not to be used on its own: most investors use EV to EBITDA to compare firms with different degrees of financial leverage and to value capital-intensive businesses with high levels of depreciation and amortization.

Jun Hao also cautioned me that EV/EBITDA is not to be used alone but together with P/B, ROIC and FCF.

Lesson 7: “Recommended reading”

Of course, Jun Hao is a very well read individual and he was kind enough to suggest some of his most important books with me. The reading list is as follows: anything Howard Marks from Oaktree Capital Management writes, Bull by Maggie Mahar, Deep Value and Quantitative Value both by Tobias E. Carlisle and There’s Always Something to Do: The Peter Cundill Investment Approach by C. Risso-Gill.

Finally, Security Analysis by B. Graham is outdated. What? Yes, the Bible of investment is outdated: the principles within it were very, very relevant to a particular moment in time and were of immense help in a period of corporate governance and disclosure were a rare thing.

Nowadays, it is nearly impossible to find a company that ticks the boxes of Ben Graham. However, I recommend that the book is still relevant from a historical perspective: learn from history even if we, psychologically, are not programmed to do so – this is another key to long-term success.

I had a nice chat with a fellow value investor in London who recorded his thoughts on the conversation, and kindly allowed me to reproduce it.

Lesson 1: “There is no single way to invest”

This was not necessarily new information to me as I was aware that investment is a profession that results in success if it is combined with one’s personality and view of the world.

Moreover, if anyone interested in investment or finance ought to read books on names such as Charles Munger, Warren Buffett, George Soros, Peter Lynch, John Templeton and Guy Spier (to name a few ‘star’ investors) then it will be even more obvious that the way these people approached the investment profession was in a unique manner that reflects the way they are as persons: from a very philosophical approach taken by George Soros to a journey seeking method adopted by Guy Spier.

However, Jun Hao confirmed this for me: he made it clear that depending on your aim (stable income, capital preservation, etc.) and on how you see the business world (i.e. how pessimistic or optimistic you are about the future of the businesses that you read about) will determine, generally speaking, what kind of investor you will be.

Moreover, he suggested that in order to improve and regardless of what path one chooses to take, reading a wide variety of books, company reports and other materials is necessary – I could not agree more on this point: reading is one of the keys for life-long success.

Lesson 2: “The future is unknown”

Nothing surprising here – some might say that this is an obvious comment. And yet, so many of us tend to allow our emotions to control our faith in our convictions: I recommend to anyone reading this to buy and ready thoroughly Influence by P. Cialdini and Fooled by Randomness by Nassim N. Taleb.

These two books will clarify why we are prone to think that the past is a good base to measure the future and why we tend to overly accentuated our faith in statistics, numbers or any form of scientific information. However, Jun Hao explained to me very clear that industries fall and rise all the time: 15 years ago the planet Earth was running out of oil and we were thinking of exploring Mars for resources.

Today, we have so much oil that supply greatly exceeds demand. Moreover, demand for non-electric cars is increasing and the pace of electric cars to punch through the established market of automobiles is still not strong enough to offer a stable projection as to when in the future the majority of the world’s population will be driving electric vehicles: the future is unpredictable. Therefore, focus on the fundamentals of the business and not on market predictions.

Moreover, Jun Hao made it clear that it is important to make the difference between a good investment and a good business: a good business is not always a good investment and a good investment is not always a good business. For example, Jun Hao explained this situation using Tesla as a model. We both share immense admiration for Elon Musk and for his companies.

However, Tesla is hemorrhaging cash!

A quick look at the financial reports will reveal that cash from financing is consistently positive and that the company is losing money for each car it sells – this means that the company has been raising cash to stay out of liquidation. This achievement is attributed primarily to Mr. Musk’s salesmanship skills. However, despite the company’s noble aim and great skills of Mr. Musk, it makes little sense from an investor’s perspective to put any money in this company: a good business is not always a good investment.

Are Investors Financing Elon Musk’s Iron-Man Dream?

Lesson 3: “Emerging markets and information asymmetry”

The reason why emerging markets are an attractive prospect for investors is because more and more local investors have access to the market but they lack the necessary skills, information and experience to actually engage in a fruitful and productive manner in the stock buying and selling ‘dance’.

Consequently, there is high volatility and many, many mispriced companies. The US market at the moment is expensive because the interest rates are low and investors are overly optimistic about the US economy and market stability.

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It’s been an interesting week, with the elections in Singapore. I am pretty surprised by the extent of the results, with this election being the PAP’s strongest in more than a decade.

DPM Tharman (Finance Minister) had the best speech by fair explaining the economic reality of welfare spending. I really recommend it. Just simple facts and logic of the matter. Politics at its finest:

BBC’s Stephen Sackur gets sucker punched by DPM Tharman at St Gallen Symposium (LINK)

Sackur: Do you believe in the concept of a safety net?

Tharman: We believe in a concept of support for you (people) taking up opportunities. So we don’t have unemployment.

Sackur: I believe in the sometimes simplicity of yes-or-no answers. What about this idea of a safety net? Does Singapore believe in the notion of a safety net for those who fall between the cracks of a successful economy?

Tharman: I believe in the notion of a trampoline (A laughter and silence in the crowd for ten seconds).

Su-Ling (Former CEO of IPCO) v Goldman Sachs International (LINK)

Ever wondered what happen to the Blumont Saga? Well, the offical Singapore investigation isn’t out yet, but here’s a related case involving the CEO of IPCO who got “margin-called” by Goldman. Funnily enough, she happened to own all of the stocks involved in the penny chip rout.

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Singapore Stock-Trade Probe Seen as Test of Credibility (LINK)

Authorities widened the probe this week to include executives from at least four more companies six months after the rout that triggered a plunge of least 87 percent in the shares of Blumont Group Ltd, Asiasons Capital Ltd and LionGold Corp over three days last October.

A lot of people are commenting on how the Emerging Markets are collapsing. Its not hard to see why with the crazy stock market and impending slowdown in China, instability in Thailand, the corruption scandals in Malaysia and the poor economic outlook of the other countries.

Sell first and think later is the watchword of the day.

And yet, by my measure, emerging market valuations are exceedingly cheap. And if we don’t buy when its cheap, when do we buy?

In the last post, I talked about how looking at the price levels are not an accurate gauge of how “expensive” or “cheap” a market is. It doesn’t take into account the economic activity over the years, reflected either through dividend payouts or increases in book value.

I am pretty bias towards the P/B ratio, just because it takes out a lot of the fluctuations in earnings. There maybe problems with it too, but I find it the best tool we have so far.

I remember back when I attended the London Value Investor Conference in May 2014, investors were already remarking that Emerging Markets were cheap relative to the rest of the world.

Where do we stand now?

screenshotCredit: JP Morgan

The data is from JPM. The data is accurate from the end of June 2015. It doesn’t take into account the subsequent decline in prices from July – August. The average P/B of the MSCI Emerging Markets stands at about 1.3x, a level not seen since 2009.

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Credit: JP Morgan

What’s really interesting from the chart above is that the cheaper the P/B ratio, the better the subsequent returns in the next 12 months.

The data goes back all the way to 1995, and it takes into account the Asian Financial Crisis in 1997.

The returns are overwhelmingly positive, which makes sense to me, as values “mean-revert”. The probability of positive returns increase significantly as stocks get cheaper. The key word here is “probability”.

Of course stocks can get cheaper, but if they go down significantly in the next couple of months, we will be already approaching 1997 Levels.

How Cheap Will It Go?

The million dollar question. Unfortunately I have no idea. All I can say is stocks are getting much cheaper. More specifically, in the markets I operate in (Singapore, Hong Kong, South Korea and Japan), I am seeing plenty of value.

Some stock valuations are as cheap as when I was starting out in 2010 – 2011.

Its probably a good time to remember that market timing is not a pre-requisite of doing well in the market. Just look at the date of Warren Buffett’s famous “Buy America I Am” piece in October 2008.

He was a couple of months early too the bottom. But that wasn’t the point, it was that valuations were already becoming very attractive. Without the help of a crystal ball, I don’t think anyone really knows when the bottom is.

I know a couple of people who are waiting for the “all clear” to buy… but lets just take a look at some of the magazine covers during one of the greatest stock market rallies in history from. These are just a couple from 2009 – 2010:

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I think it just goes to show how hard it is to predict the future. I will probably do a future post. Reading these articles written in the past are tremendous fun, as are the comments made then.

Final Thoughts:

So I think stocks are pretty cheap across the board, and its time to go bargain hunting. Still, the news in the coming months will probably be pretty bad, and anyone looking to commit should steel themselves mentally and be prepared to look foolish in the face of a wall of negative press.

 

The truth about our corporate ventures is quite otherwise. Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time.

Remarkably few, also, of the larger companies suffer ultimate extinction. For most, their history is one of vicissitudes, of ups and downs, of change in their relative standing.

In some the variations “from rags to riches and back” have been repeated on almost a cyclical basis—the phrase used to be a standard one applied to the steel industry—for others spectacular changes have been identified with deterioration or improvement of management.

– Benjamin Graham, The Intelligent Investor

 


Investors watch computer screens at a stock exchange hall on May 8, 2015, in Fuyang, China.

Weekly Readings:

Investors take a second look at EM as China fears cool – (LINK)

The average price-to-book ratio for stocks on the MSCI EM index is now less than 1.3 times, a level not seen since early 2009, when emerging markets were still reeling from the impact of the financial crisis, according to Teverson.

A price-to-book ratio is used to compare a stock’s market value to its book value, and is a key metric used by traders to gauge the value of equities.

Heard of China’s Fake Rolexes? Now There’s a Fake Goldman Sachs – (LINK)

How to invest if you have $20k or more – Why we think The Straits Times is Wrong – (LINK)

STI ETF beat 7 unit trusts based on a 10-year performance. And the difference between STI ETF and the top fund is only 0.2%.

Trump Has Done Well, but Not as Well as the Stock Market – (LINK)

If Trump had done that in 1988, he would be worth $13 billion today, more than triple the Forbes estimate.