Evaluation, Management and Choice of Stocks

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Chapter 5: Evaluation, Management and Choice of Stocks

5.1 Stock Evaluation Method

The following methods use historical data for evaluation. It should be used along with unquantifiable parameters such as management quality, company prospect, politics, economics and company policies.

Number	Parameter	Equation
1	P/E Ratio	price per share / earning per share –> {years to breakeven}
2	NTA (Net Tangible Assets per Share)	shareholder fund / number of shares = [(paid-in capital) + (company reserve)/ number of shares]
3	DY (Dividend Yield)	dividend per share / price per share
4	Times Covered / Dividend Coverage Ratio	net income / dividend declared
5	Current Ratio	current assets / current liabilities
6	ROE (Return of Equity)	net income / shareholder’s equity = net income / [capital + company reserve]
7	Cash Flow	from annual and quarter report

5.2 Stock Price Prediction and Stock Selection

1. Lowest P/E ratio (< 10 ~ undervalued) + 10% annual profit = best

2. Investigate industry
   • e.g. plantation with high unharvested land mass
3. Cyclic stocks
   • e.g. steel industry from 1997 - 2003
4. Banking stocks
   • e.g. improving economics will improve rate of receivables, thus improving profit
5. Production stocks
   • Large CAPEX (Capital Expenditure) –> improved production [see 5.4]
6. Quarter report
   • quarter EPS could be used to estimate annual EPS by multiplying with 4 (quarters)
   • annual EPS * P/E ~= estimated share price after 1 year

5.3 Evaluating Agricultural Stock

In Malaysia, agriculture industry has relatively stable profit. In addition, the land prices hike consistently making investing in agricultural stocks somewhat similar to purchasing land.

Benefits of Agricultural Stocks

1. Listed companies usually possess land of better quality indicating high yield potential.
2. Listed companies usually equipped with professionals and shareholders could just enjoy the potential benefit with less effort.
3. Listed companies equipped with research facilities are capable of producing better breeds of crops.
4. Listed companies eqipped with processing mills reduce the capital required and increasing profit.
5. Agriculture companies with large land mass could potentially gain enormous profit by selling possessed land for better purpose.
6. Oil palm has many use with increasing need (especially 3rd world countries), the demand will not be depleted soon.

The share price of agricultural stocks could be estimated by determining:

1. Plantation land area owned by the company
2. Price or land per area
3. Compared with current share price (including Net Profit/ Loss

5.4 Discovering Growth Stock

The accepted notion for investment:

Growth –> Profit Increase –> Share Price Increase

CAPEX (from Cash Flow Statement under Cash Flow from/ for Investing Activities)

• Only suitable for companies with tangilble assests
• e.g.: manufacturing, real estate, and agricultural
• Companies with large CAPEX usually experience exponential growth on profit and share price after 1/2 years
• CAPEX usually includes regular maintenance cost (does not increase production capacity) under "Acquisition of PPE"
• Only when there is huge increase in "Acquisition of PPE" that there is potential growth
• CAPEX includes property, plant and equipment (PPE)
• Common reason of increasing CAPEX is demand » supply
• Booming Production
• Production achieved optimum size
• Company Investment on New Equipment
• Launching of novel product

Example 1: JHM

• LED production company
• JHM stock rise from below 0.6 / share to above 6.00 / per share from 2016 - 2017
• Between 2013 - 2016 the company experience unusually huge CAPEX

JHM

Year	CAPEX (mil)	Revenue (mil)	Net Profit (mil)
2016	3.4	193.7	20.3
2015	7.4	131.3	6.4
2014	6.6	71.8	(1.1)
2013	9.1	69.4	2.2
2012	0.7	63.3	2.2
2011	2.5	64.6	1.8
2010	3.9	49.2	1.5

Example 2: 3A

• Food additive production company
• CAPEX between 2015 - 2016 is 7 times of between 2013 - 2014

3A

Year	CAPEX (mil)	Revenue (mil)	Net Profit (mil)
2016	27.6	387.7	38.9
2015	27.8	352.2	20.1
2014	2.5	311.4	18.2
2013	5.4	302.9	10.3
2012	17.7	309.4	16.2
2011	20.5	269.0	15.3
2010	38.9	249.0	16.9

Example 3: Johotin

• Can production company, afterwards transformed to dairy production company
• Starting from 2013 CAPEX is continually increasing

Johotin

Year	CAPEX (mil)	Revenue (mil)	Net Profit (mil)
2016	10.4	441.2	35.4
2015	25.3	417.4	17.3
2014	12.6	316.8	13.0
2013	16.8	241.1	20.5
2012	8.9	246.3	22.8
2011	1.6	134.2	11.0
2010	0.9	95.5	6.2

Example 4: Hovid

• 2010 - 2014 having limited CAPEX that only allows maintenance instead of improving production
• profit was not satisfactory
• 2015 - 2016 CAPEX was 2.5 times of the sum of previous 5 years
• the investments were towards establishing 2 medication production plant, 1 multi-storey storage, 48 beds medical research centre
• transforming to exporting products

Johotin

Year	CAPEX (mil)	Revenue (mil)	Net Profit (mil)
2016	44.2	189.0	18.1
2015	27.2	188.4	20.9
2014	6.3	183.5	19.3
2013	3.2	172.5	38.7
2012	7.7	164.8	15.8
2011	3.3	153.8	(6.1)
2010	7.3	365.1	(92.5)

5.5 Decision on Buying Stocks

1. Establish correct mindset on stock investment
   • Profit high –> value increase ; profit low –> value low
   • with short term fluctuations, in the long run the value will approach the actual value
2. Profit comes from product
   • is the product sellable to make profit?
3. Product market
   • how sellable is the product?
4. Every industry will have competition
   • Only those with optimum quality and price will monopolize the market
   • Could be measured using market position
5. Company management
   • Good management ensures production with minimum cost
6. Company culture and policies
   • Good management requires good talents. Only good company culture and policies that could retain good talent.

5.6 Only Purchase Listed Stock

• Quality stocks only occupies 10% of the whole stock market.
• To create the 10% List, substaintial understanding on each company is essential for comparison.
• Set a personal standard according to personal needs (need == dividend? invested capital value increment?)

5.6.1 A Good Notion on Choosing the List

1. Identify stocks with no value.
2. 1st round: Listed financially distressed companies [est. 100 identified]
3. 2nd round: Companies with no obvious profit [est. 300 - 400 identified]
   • i.e. annual loss/ fluatuating and remain constant after 8 - 10 years
4. 3rd round: Unpopular stocks [est. 300 - 400 identified]
   • low stock flow volume
5. Select from those that are not in the identified stocks. [est. 100 selected]
   • could be 50
   • from the selected list choose 10 - 20 companies that are familiar

5.6.2 Characteristics of Stocks in the Final Selected List

1. Growth potential
2. Award dividend
3. Logical share price (based on P/E ratio)
4. ROE (> 10%)
5. Postive net cash flow
6. Strong free cash flow

5.7 Stock Portfolio Management

• A stock portfolio is a collection of invested stocks spanning across field and industries.
• 1st: Reduced risk through diversification
• 2nd: Obtain better and stable reward
• Core of huge investment organizations. However, important understanding for small fry like us too.

5.7.1 Modern Portfolio Theory (MPT) | from “Portfolio Selection” by Harry Markowitz

• Proves that risk of investing a collection of stocks is way lower than individual stocks.
• Main aim is to reduce risk while increasing return.

5.7.2 Challet and Umbrella | from “A Random Walk Down Wall Street” by Burton G. Malkeil

Imagine a challet with clear weather annually in the first half of the year and rainy weather for the rest of the year. Loss is inevitable for half of the year. On the other hand, an umbrella company would gain profit at the same half of the year period. Why not invest half in each company to ensure income throughout the year?

• The above notion is essential for unit trust as they require consistent income to retain investors.
• An indeed realistic notion with reduced risks.
• However, problem lies in the implementation of the diversification.

5.7.3 Digging Deeper into Portfolio Diversification

1. Diversification of industry
   • Avoid from investing in various stocks from the same industry.
   • Avoid investing too much in certain industry (balance is the key).
   • Most funds view safety first and profit second. Main reason for unattractive offers from most funds.
   • Ensuring reduced risks.
2. High Beta High Risk
   • Beta: Indicator for volatility of stock price compared to overall stock market.
   • High Beta （Radical） –> High volatility; Low Beta (Conservative) –> Low volatility.
   • Beta > 1 == High price swing; Beta < 1 == Low price swing.
   • Does not indiciate the actual value of a stock
3. Waves from External Investors
   • Some investors deemed that investing solely in a country’s stock market still possess high risks.
   • They choose to diversify their investment in stock market across various countries,
   • This is especially impactful when they involves investment of European/ American organization in the stocks of developing countries.
   • Due to the sheer amount of external investment, the influence of foreign investors should not be undermined.
4. Buffett’s Impact
   • Warren Buffett do not agree with over-diversification of portfolio.
   • He emphasizes on pinpointing potential stocks and pumping heavily on the target.
   • Therefore, stocks under his management are limitted centring around few core stocks with high shareholding percentage.
   • He believes that the success of investors is determined by their understanding and familiarity towards the industry.
   • Although his method is proven from his results. I believe that it is not suitable for most commoners like me who do not have time to spent fully on stocks.
5. 3 Rule of Thumbs for Commoners
   1. Invest in Long-term Stocks
      • Investment risks is usually inversely proportional to the investment term.
   2. Dollar-cost Averaging
      • Basically is investing an equal amount at regular interval no matter what is the current share price (e.g. RM500/ month on GENM).
      • The strategy aims to reduce the impact of volatility by averaging the total invested capital.
      • Do not focus on just one stock.
      • American usually adopt this strategy in unit trusts to reduce risks.
   3. Focusing More on Growth Stocks with Smaller Capitals
      • From author’s experience, within one portfolio, if the growth stocks with small capital is the majority, the return is satisfactory.

5.7.4 For Small Fries with Little Money Like Me

1. Engage in long-term investment
2. Adopt Reverse Scale Strategy
3. Try your fcking best to understand your targetted company.
4. Stick super closely to the progress of the company (e.g. Annual + Quarter report)
5. Be deligent in your stock studies.

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Reference

[1] 冷眼, 30年股票投资心得. 马来西亚: 辉煌世纪, 2018.