Tuesday, August 31, 2010

Benjamin Graham's Valuation method

In his book, The Intelligent Investor, Ben Graham provides an alternative straight-forward formula for calculating fair value of 'growth' stocks.

This formula is intended to produce results similar to those from more refined mathematical calculations such as discounted cash flow (DCF) calculations.

His formula is:
Intrinsic Value = Current (Normal) Earnings x (8.5 + twice the expected annual growth rate)

He discounts the intrinsic value to provide a margin of safety. He suggests that the growth rate should be that expected over the next seven to ten years.

Take Singtel (EPS : 24.55)
Very difficult to estimate growth rate but considering it is in a mature industry, let be very conservative, take annual growth rate to be 2%)
So, intrinsic value = 24.55 * (8.5 + 2*2) = 3.07
This a very rough estimate, but it give me confident that whenever Singtel drop below 2.8, I will start to buy progressively..
 Take StartHub (EPS : 18.68)
Let take growth rate to be 1.5% since StartHub only operate in Singapore so growth rate should be lower than Singtel

So, intrinsic value = 18.68 * (8.5 + 2*1.5) = 2.15

Again, I will consider buying in when StartHub is below 2.15 since StartHub business is probably more stable than Singtel due to the lack of overseas exposure.

Why do I choose Singtel and Starhub for this analysis. It is because Telcos business is inherently more defensive and stable relative to others. So the earning figures we use should be relatively more reliable. However, you do need to watch out from for major trends in telecommunications as mature business can undergo decline eg postal services

Monday, August 30, 2010

P/E Ratio

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

Typically, P/E ratio can be trailing (based on the last 12 months earning results) or forward (based on analyst expection of the next 12 earning results).

If the last twelve months have been a bumper year for the company (especially if there one-time gains), the trailing P/E ratio may look very good, but you have to discount it quite a bit if you are considering to buy at this stage.

If the last twelve months have been very bad for everybody (like March 2009), the trailing P/E ratio may look worse than they really are.  If the company is fundamentally sound, this may be a good buy opportunity though P/E may look lousy.

As for forward P/E ratio, the general rule will be to always discount it to some degree when the mood is bullish. Analysts are always too bullish or pessimistic. How come few analyst cry out for "Buy" in march 2009??

P/E ratios fell sharply during the Great Recession (2009/2009), Sars and 1997/1998 crisis.

If corporate borrowing costs remain at record lows and specific stock prices remain lower than expected, companies will start issuing debt to buy back shares from the market. Recently, you would SingPost doing a lot of share-back after raising fund from the debt market.

Always remember, a stock is only worth its future earnings, but it involves uncertainty. This explains the need to have a "margin of safety" in value stock investing.

Sunday, August 29, 2010

Watching out for Red Flags

Accounting is not a black-and-white process. There are dozens of techniques that are legal and aboveboard, which have the effect of moving numbers around. This may fool the casual observer into thinking that all is well and the company has posted true operational improvements which in reality it is not.

In general, when you are combing through the annual or quarterly reports,watch out for the following:-

1) Declining cash flow. If you continuously see cash from operations decline even as net income trends upward, watch out.

2) Be wary of firms taking frequent one-time charges and write-downs. When a firm take a big restructuring charge, it is essentially trying to improve future results by pulling future expense into the present. DBS recently took a $1 billion goodwill charge, so I am watching this closely as the shareholders are paying for management overpaying for Dao Heng Bank. In addition, try to be careful when Goodwill and intangibles form a large percentage of the firm's net assets.

3) Serial Acquisitions where financials have to be restated and rejiggered until it is difficult to get the true picture of what is going on.

4) CFO leaving the company when accounting issues arise

5) Track how fast A/R are increasing relative to sales. If A/R is increasing by 25% when sales is only increasing by 15%, imply that the firm is booking sales faster than it is collecting cash from its customers. Try to understand it there are any changes to credit terms. A lot of US software in the past "forces" the sales to book any order possible before the quarter closes. Typically some of these will turn out to be "lemons" later on.

6) Gain from investment. An honest company will break this out from sales and report them below "operating income"  line in the income statement. That means the firm is not trying to boost operating results of its core business.

7) Overstaff inventory. When inventory start to rise faster than sales, there might be trouble on the horizon. Try to understand what this rise of inventory is really for. Also, valuation of inventory should always be taken with a grain of salt. For example, for an apparel company, holding a large inventory of last year fashion is surely a sign of trouble.

8) Changing assumptions in the financial statement. Examples are changes in the rules on how depreciation and allowance for doubtful accounts are relaxed.

9) Watch out for how cost are expense or capitalize. I take the case of StarHub. StarHub last two quarter performance is no good. One of the major factor that the management clarify is that they are expensing all their investment in smartphones rather that capitalizing them over the lifetime of the contracts. I think, if this is true, this will be very conseravtive accounting policy which I like ( I believe M1 capitalized the subsidies over the lifetime of the contract, so their performance look better at this stage). Hence, I continue to hold on to my StartHub shares.

Tuesday, August 24, 2010

Dividends in August

I have received dividends for the following in Aug this month:-

Suntec Reit

Total amount is $2839.64

Sunday, August 22, 2010

More on Valuation - Intrinsic Worth

How much are stocks worth? They are worth the present value of their future cash flow. That value is determined by the amount , timing and riskiness of the cash flows.

To calculate the intrinsic worth of a stock, some concepts are needed. First, the discount rate (R) which equal to the time value of money plus a risk premium. The risk premium is tied to factors like size, financial health, cyclicality and competitive positioning of the firm under evaluation. Finally, there is a very long term estimated growth rate of cash flow (g).

To calculate the intrinsic worth, follow five steps:

1) Forcast free cash flo (FCF) for the next 10 years

2) Discount these FCFs to reflect the present value
     Discounted FCF = FCF for that year / (1+R)^n
     (where R is the discounted rate and n is the year
     being discounted)

3) Calculate the perpetuity value and discount it to the present
     Perpetuity Value= FCF(n) * (1 +g) / (R - g)
     Discounted Perpetuity Value = Perpetuity Value /
     (1 + R)^n

4) Calculate total equity value by adding the discounted perpetuity value
     to the sum of the 10 discounted cash flows in step 2
     Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash

5) Calculate per share value by dividing total equity value
     by shares outstanding
     Per Share Value = Total Equity Value / Shares Outstanding

Thursday, August 19, 2010

Valuation Metrics

When you buy a company stock based on value, you are trying to pay a price based on what you perceive the value of the company plus your margin of safety. Whe you speculate, you are buying stock of a company based on what you think is the probability that there will be a buyer out there who will be willing to purchase your stock at a higher price. In general, SPECULATE at your own risk though I do not deny that occasionally you can make some easy money.

In general, be picky about valuation and do not rely on a single valuation metric because no individual metric can tell the whole story. You may not need to have a finance background ( I don't), but when you start practising how to look at these metrics, you will less likely buy/sell on impulse or hearsay than warranted.

1) For firms that is cyclical or has a spotty earnings history, use price-to-sales (P/S).Companies with P/S ratios lower than their historical average can be bargains sometimes, but pay attention to net margin. In general, firms with higher net-margin warrant higher P/S ratio. In general, industries with higher net-margin tend to be those with higher barrier to entry or wide economic moats.

2) The price-to-book ratio (P/B) is most useful for financial firms and firms with numerous tangible assets but least useful for service oriented firms. In general, firms with typically higher ROE would be worth a higher P/B ratio. For example, my average purchase of DBS is at P/B ratio of 1.07 ( after taking in consideration of the recent $1 billion Goodwill impairment).

3) Compare a company's P/E with the market, a similar firm or the company's historical P/E. Be aware of different growth rates or risks between the companies you are comparing. When comparing with the company's historical P/E, try to understand if the company's macro operating has changed. For example the average P/E of Singtel from 2000 to 2009 is 13.4 (minimum is 8.9, max is 15). My average purchase price of Singtel is at P/E 11.8.

4) Use PEG (PE over growth rate) with caution as fast-growing firms tend to be riskier

5) Check earning yields (inverse of P/E) and cash return (Free Cash Flow over Enterprise Value). Enterprise Value is simply the firm stock market cap plus its long term debt minus cash). The goal is to measure how efficiently the business is using capital (both debt and equity) to generate free cash flow.

Tuesday, August 17, 2010

Timing The Market?

Market Timing is one of the all-time great myths. There is no strategy that consistently tells you when to be in the market and when to be out.

There is a study in the February 2001 issue of Financial Analysts Journal, which looked at the difference between buy-and-hold and market-timing strategies from 1926 through 1999 in the US using a very elegant method.The authors mapped all the possible market-timing variations between 1926 and 1999 using different switching frequencies.

They assumed that for any given month, an investor could either be in T-bills or stocks and then calculated the returns that would have resulted from all the possible combinations of those swicthes. For the curious, there are 4096 possible combinations between two assets over 12 months.They then compared the results of a buy-and hold strategy with all the possible market-timing strategies to see the percentage of the timing combinations produced a return greater than simply buying and holding.

The answer is about one-third of the possible monthly market-timing combinations beat the buy-and-hold strategy. However, given that stock market returns are highly skewed eg the bulk of the returns (positive and negative) from any given year comes from relatively a few days in that year, the risk of not being in the market is high for anyone looking to build wealth over a long period of time.

Thus, I would not recommend anyone to use a market-timing strategy to manage your DIY portfolio for the long term. Having said this, this is not the same as saying that you should never sell your stocks. We will look at a future post on when you should consider to sell some of your stocks.

Monday, August 16, 2010

Portfolio Composition Considerations

There are various options for anyone to park some of their excess cash eg fixed deposits, bonds, equities, commodities or property. The typical recommendation is that depending on your risk profile, you should allocate a certain portion to cash, bonds and equities. As for commodities (eg Gold) and property, it will depends on the environmental factors and well as specific individual inclination. Investment in property is by large illiquid and cost prohibitive (especially for your second or third properties).Of course, if you are rich, this is not an issue, but for an average guy like me, it is a problem.

For an average singaporean investor, the options to purchase corporate bonds directly at this stage is quite limited though changes in SGX are on the all next year that may make it easier. I will relook at my bond strategy when this happens. You can look at some bond funds, but I prefer to do it the DIY way as I believe there is no free lunch.

To buffer my porfolio with a bond-like component during the 2008/2009 crisis, I purchase a substantial amount of OCBC and UOB Preference Shares at issue. They are not exactly like bonds, but behave more like bonds than equities. Later on, I purchased some amount of SGX bonds through FundSupermart. With both measures, I have currently about 35% of my portfolio in Pref Shares and SGX bonds. This give me a sense of calm especially the market turned bad eg during the recent PIIGS crisis. Short of OCBC or UOB going belly-up and maybe mayhem in singapore, I think these instruments are relatively safe from day-to-day volatility.

A further 35% of my portfolio is into defensive yield equities eg (SPH, CitySpring, SP Ausnet, SBS, SMRT, STarHub,Singtel, FirstReit, Suntec Reit, Ascendas India, CMPH etc). They give me healthy dividends income but I do not expect significant price appreciation from these counters.

The rest are into bank (DBS), property (Capitaland), Shipping (Cosco), Sembcorp that will do well faster if economy propers but dip faster if condition deteriorate.

I know this is probably not the best allocation but it serves my purpose at this point. I do not set out with this specific objective, but some how along the way, I work things out this way. This is one of the reason that I set up this blog, to create a sharing forum for average investors who want to do it the DIY way.

Right now, my porfolio has one glaring omissions eg small growth stocks. I will share my thoughts about these in another post later.

Sunday, August 15, 2010

Here is my current portfolio

Below is my current portfolio with the average purchased price including transaction charges. I am a firm believer that you need to include the transaction charges to reflect the actual costs of your purposes. They are not listed in order of size of my holding at the moment. The current total estimated portfolio size in excess of one million dollars at this stage. Let me know if there any any good value stock that I left out. I current invest primarily in the Singapore market.

DBS Bank
Semcorp Industries
SP Ausnet
Suntec Reit
First Reit
Ascendas India
SBS Transit
China Merchant Pacific
UOB 5.05% NCPS
SGS Bonds

Thursday, August 12, 2010

My First DIY Value Investing Post

My Current Portfolio

Over the last two years, i have build up the my portfolio from an all cash position. I was a bit early when I start shifting from cash to equities prior the 2008 crisis by 3 months. However, since I went in slowly, I did manage the catch the low and end up with quite a substantial gain till now. Previously, I touched equities sparingly and got involved in a lot of structured  products offered by the locals banks that claim to offer protection of principal. The returns are abysmal. The lesson I learnt to date is that for most small investors (from a few thousands to a couple of million), you might be better off if you take a more proactive approach.

Currently, I am deriving about 4.5K per month passive income based on my investments alone. I am quite conservative as you would see from my portfolio and I would certainly welcome feedback and suggestions for improvements or retuning.