My Fundamental Philosophy to buying stocks.
There are many reasons share prices appreciate, such as technical (profit-taking, short-covering, etc), psychological (market sentiment) and other miscellaneous reasons (merger and acquisitions, take-overs, BBs pump-and-dump manipulation etc), but i believe the foundation of major, long-term share movements stem from the company fundamentals. The fundamentals are akin to the centre of gravity of a stock, in which all other factors revolve around and gravitate towards.
I also believe fundamental analysis is generally the easiest to learn, and is suitable and applicable for all market players. FA is especially important to long-term investors, but I believe even day-traders will find it helpful to know the long-term/primary trend of a stock which is strongly related to its fundamentals (the best trades are those that align short, mid and long-term timeframes). Of course, not everyone is suited for FA, but i believe basic FA can be quite easily understood and utilised by most people.
I believe the decision whether or not to buy/sell a stock based on FA can be condensed into just two concepts; 1. sustainable profit growth and 2. market valuation. Concepts such as P/E, equity, debt, profit margins, assets, liabilities, cashflow etc are only relevant insofar as they relate to the 2 concepts mentioned. I won't buy a stock with 'undervalued' price-to-book ratio, great cashflow, low p/e, no debt, high profit margins, but poor earnings, but i will happily buy a stock with 'overvalued' price-to-book ratio, negative cashflow, high p/e, high debt, low profit margins but fantastic, sustainable earnings growth.
Capital seeks growth and appreciation; that is the underlying principle behind the flow of money in finance. People seek to grow the value of their money by putting it where it has the best chance to grow. When they think putting their money into a stock can give them the best returns, they buy the stock, and when demand > supply, causes the price of the stock to go up. In the end, investors are really looking at which company can best grow their earnings and intrinsic value, which will give a return on the capital they used to buy the share in the form of either dividends or capital gains.
Earnings/net profit is the single most important indicator of a company's value and well-being. It does not matter how much cash-on-hand a company has, or how undervalued their Price/book ratio is, if it cannot be profitable (unless its so undervalued you can take over the company and make a profit liquidating everything). It is like buying a factory that produces flip phones or typewriters. You can get the previously-expensive machinery for a cheap price, but it is useless as the equipment it manufactures is obsolete. The only way you can make a profit is if you can sell the factory as scrap for a better price than what you paid to acquire it. Conversely, if you happen to find and buy a secret algorithm that can let you win the lottery every week (fantastic, sustainable earnings), it is still worth buying even if you have to borrow enough money to buy and own it, and even though the algorithm costs nothing to produce (its just a mathematical formula). Experienced investors all know that earnings is the strongest driver of share price as it is the best indicator of a company's value. A stock that has the best potential and likelihood to grow its profit is the stock that is most likely to appreciate in value.
The other factor to consider is market valuation. Market valuation is the price the market has decided to value the stock at, and the price one has to pay to own the stock. A company can have amazing sustainable profit growth, but such a company is also likely to have been noticed by the market. As such, there is a high possibility that the market valuation will reflect that growth. To use an extreme example to highlight how important market valuation affects the returns a person can get, consider these two scenarios; Stock A has a CAGR of 50%, but its P/E is currently 1000. Stock B has a CAGR of 30%, but its P/E is currently 10. Although Stock A has a higher CAGR, it would take 33 years before the P/E catches up to that of Stock B. And a lot can go wrong in 33 years! The risk of growth stocks is that they stop growing, thus leaving the buyer with a stock with high p/e but minimal growth. The principle to keep in mind is that a great stock can be too expensive to own, but a bad stock is rarely worth buying cheap (ignoring non-fundamental reasons like technical rebounds, take-over rumors, etc)
1. Sustainable profit growth
Profit growth measures the increase in profits a company can be expected to have. Ideally, we want a company that can grow its profits as much as possible in the shortest amount of time. To find such a company, we must look for indicators present in a company that suggest that good profit growth can be expected.
An important caveat is that such profit growth must be sustainable. If a company grows its profits, but takes on so much debt to do so that the debt payments eventually snowball at a faster rate than its profit growth, such profit growth is unlikely to be sustainable or becomes vulnerable to a 'shock' event or competitor that suddenly depresses profits. Or, the profit growth is due to a temporary, short-term spike in demand or contraction in supply, and simply fades away when conditions reverse. This concept comes into play when analyzing the quality of a company's profit growth in the past, present and future.
For me, the most important thing to look out for is the quality of the company management. A management that has successfully grown the company in a sustainable manner over a long period of time suggests that the company will be able to maximally profit in good times and survive during bad times. Typically, good management is one with a long track record of building up and growing the company through good times and bad. Examples of stocks with good management are Riverstone and Cogent, companies that have grown and expanded significantly throughout the years, enabling their shareholders to reap the rewards in dividends and capital gains. Examples of bad management are that of Noble, whose founder Richard Elman successfully turned a company he founded with 100k into one worth billions during the commodity boom cycle, but failed to manage it properly when commodity prices tumbled. It doesn't matter how 'undervalued' Noble appears to be at the moment for as long as the management is poor, the company will likely continue rotting away. In contrast, Glencore, which was also heavily involved in commodities, also suffered when the commodities bubble burst, but managed to restructure itself properly and retain most of its value.
We also want to see management owning a significant share of the stock holdings; skin in the game guarantees that the management will be trying its best to provide shareholder value by growing and managing the company well as well as giving out dividends.
The next important factor to consider is industry prospects. Consider such prospects in terms of cycles. Cycles can manifest in different forms; long and short-term cycles, technological cycles, commodity cycles, macro and micro cycles;
Singpost obviously cannot make money anymore through transporting physical mail (email is just better), but it can reinvent itself to capitalise on e-commerce by transporting products bought online. Physical mail is a cycle reaching its death, but e-commerce is a cycle in its growth phase. Whether or not the company can successfully transition into the new technological cycle will depend on the quality of the management.
Commodity cycles are especially volatile, such as those of oil and gas, gold, metals, palm oil, etc. Consequently, stocks involved in commodities are likely to literally boom or bust accordingly. Again, good management enables companies to capitalise during boom cycles, and keep afloat during bust cycles (noble vs glencore) although perhaps there are certain conditions so trying that the best management cannot cope with.
Macro cycles such as general economic conditions, or political tensions, have a 'general' effect on the stock market and profitability of companies. These cycles are relevant to retail sectors such as REITs, supermarkets, and luxury good/service providers as consumer confidence and purchasing power ebb and flow accordingly.
The most cycle-independent stocks are those regarded as 'defensive' stocks. These stocks are 'defensive', as they usually provide necessities that are in demand all the time. Telco stocks, utilities, waste management are all examples of necessities which are minimally affected by macro cycles, although the share price could still be affected as capital flows into defensive stocks during 'bad' times and out when conditions improve.
What we want to do is to buy a stock at the beginning of a 'boom' cycle and exit before the 'bust' cycle. Certain stocks are more vulnerable to cyclical effects, but in fact all stocks are impacted by cycles.
Finally, it is important to ensure the sustainability and quality of profit growth. What we want to see in the balance sheet are finances that support and reflect sustainable, quality profit growth.
Sustainability refers to the period of time we are prepared to hold the stock. In cyclical industries like tech and commodities, it is unrealistic to expect consistent profit growth year-after-year since these industries are very cyclical in nature. Instead, look to see how sustainable the boom cycle can last, and adjust accordingly. A company can demonstrate rapid growth in its history, but completely stop still in its growth as it reaches the maturation stage, or when the boom cycle ends.
Debt and operating cashflow are important factors to look at, but are often mis-evaluated. For growth stocks with low profit margins or speculative stocks involved in mining exploration, debt is often a necessity in order to fund growth and operations. However, if debt is accumulated and wasted with no returns, it becomes a red warning sign to the sustainability and quality of the company's management and bottomline. Conversely, having huge cash reserves with no debt can either be a sign of wise, conservative management, or an indicator of a complacent, unambitious management with no drive or vision to grow and expand shareholder value.
Equally, we want to ascertain the quality of profit growth. 'Fair value gains' and one-off gains or divestments can grossly distort the earnings displayed on the balance sheet, but are inescapable for certain sectors like property and construction. I personally have no idea how to evaluate such gains, and as such, I stay away from property stocks.
Profits can fluctuate due to controllable and non-controllable factors; uncontrollable factors are cost of raw materials, foreign exchange, unforeseen changes in the operating environment (political, economic or otherwise), controllable factors can rarely be isolated on the balance sheet and is best indicated by revenue growth or sales volume. If profit growth is accompanied by consistent revenue and sales volume growth, we know that the company is likely to be successfully growing independent of uncontrollable factors. If it is due to better profit margins, we want to see that these better profit margins are due to controllable factors such as improved economies of scale due to successful relocations or changes in processes, changes in product mix, or long-term adjustments in business strategy.
The only importance i assign to details such as current/non-current assets, liabilities, cash flow, etcetra is what they tell me about the company's earnings potential.
Accounting fraud is an infrequent but significant occurrence. When things look too good to be true, you better check if its true. The best way to avoid accounting fraud is to assess whether all the above variables converge on the positive growth story. If the management has a long track record of being honest and successful, is a big shareholder of its own stock, if the company is riding a boom cycle, if the improving profits are backed up by controllable factors, if dividends have been given regularly (dividends are earnings the company must have in order to distribute), if the earnings are of a sustainable and quality nature, then we can have strong confidence that things are good and true.
A stock can have a great CAGR (Compound annual growth rate) and yet be too expensive to buy. I personally experienced such a phenomenon. When i bought my first stock, i spotted Citic Envirotech which had a massive 30+% CAGR for the last five years. I bought it at 80c in February, but the share price did not move by much and is currently at 76c with a P/E of 20. The reason for its lack of movement is simply that its P/E was too high when i bought it. Furthermore, as the company reinvested most of its earnings into growing its operations, it did not distribute much dividends. I believe that the P/E of 20 is relatively cheap and the share price should hit 90c within this year, but the short-term upside is minimal due to the high valuation.
Think of P/E in dividend terms. Assuming a company gives out 100% of its earnings as dividends, if you bought a share at 10 P/E, 10 dollar of shares bought would give you a 10% return in the form of dividends so you receive 1 dollar in return. However, if the company doubles its earnings next year, so does your dividends received, so you receive 2 dollars for the 10 dollars of shares you paid for, giving you a 20% dividend yield. Of course, a 20% dividend yield is massive, and capital is likely to flow into the share. If sufficient capital flows in to the stock such that the P/E remains at a 10 despite the doubled earnings, this means price must have doubled. If you sold your share at this price, you essentially doubled your return in one year. Of course, with the exception of Reits and Trusts, most companies don't give 100% of their earnings as dividends, often choosing to retain part of the earnings to reinvest into the company. I believe that consistent, growing dividend payouts demonstrates a management that is confident in its business model and cares about shareholder value, and the presence of a sizable dividend payout almost always causes a stock to be valued more highly than one without decent dividends.
The counter-example to Citic Envirotech was China Sunsine Chemical, an S-chip with a far lower CAGR of 10%, but available at an incredible 5.5 P/E. This meant that if it gave out 100% of its earnings as dividends, i would have a dividend yield of nearly 20% immediately! This was an extremely solid stock that was the market leader, had a sustainable growth trajectory, no debt, and an excellent track record. The reason it was undervalued was mainly due to S-chip stigma, and its low dividend payout prior, as it focused on paying off its debt and expanding its operations. Furthermore, its share price and liquidity had picked up in recent months, suggesting that the market was now noticing this counter, and further re-rating was imminent. As such, just a few weeks after buying it at an average price of 56cents, the share appreciated to 74c, making me a very solid 28% return as I sold it at 72c.
Of course, companies with low P/E often have low P/Es for good, or rather, bad reasons. Usually, it is because of a one-off divestment gain, or because the company is entering a bust cycle, and its low p/e is due to the market selling off its stock. Whilst it may have a superficially low p/e, it is likely to encounter declining earnings in the next few years, thus the forward P/E may be much higher or even non-existent due to losses incurred. However, when you do come across healthy companies with low p/e and good growth prospects, look carefully to see whether you have a gem or a fake on your hands.
The significant difference between companies with low P/E and good growth prospects versus companies with high P/E and great growth prospects is this; good companies with low P/E are underappreciated, and just need to maintain their performance and wait for the market to notice and appreciate them, whereas high p/e companies with great growth prospects MUST maintain their high growth rates for a few years before they justify and compensate their high P/Es. Naturally, it is easier to grow slower consistently, than to grow quickly constantly, which is why a low p/e company with good growth prospects is generally a better and safer bet over a high p/e company with great growth prospects. That, i believe, was the reason why China Sunsine Chemical appreciated so much faster than Citic Envirotech; China Sunsine's low P/E meant that it was already undervalued, whereas Citic Envirotech needed to perform very well for the next few years to justify its P/E. This is why market valuation is as important as earnings growth; the former tells you how valued a stock is now, whereas the latter tells you how valuable a stock could become.
In my stock selection, I have my own views on risk-management and capital appreciation, but to put it simply since i don't want to digress, I believe in putting my capital in the stocks with the best growth potential, and fulfills the above criteria i have set out. There are many good stocks, but i only want to buy the best. And so far, 3 stocks best fulfill my criteria, though I have my eye on several others which come very close.
1. AEM (20% of my portfolio)
AEM is the most recent star stock of SGX, having climbed 900% within less than a year, from 30c in Nov to 2.70 today. The reason for its steep surge in share price was due to a combination of a 1.turnaround situation and 2. an amazing growth story. In 2012, it had began to restructure its business product mix, and began heavily investing in R&D to create a new product that would blow away its competition. What it came up with was a new high density modular test generation semiconductor handling platform which began mass volume production in the second half of 2016. During the time in which it invested in R&D working on its new product, profits naturally suffered, which in turn depressed the share price. However, once the new product successfully launched, AEM had turned the corner and would see profits grow rapidly as it exited the bust of the previous tech cycle and entered the boom phase of a new technology cycle.
However, the boom cycle has only just begun. AEM only moved into mass volume production in the second half of 2016, and its productive capacity is far from maturity. This means that there is still plenty of room for growth in its near future, which is corroborated by the own bullish outlook of AEM in its 2016 Annual report as well as the extreme growth in sales orders it has announced. In addition, most market observers should very well know that we are entering a semi-conductor boom cycle, and many semi-con/ electronics related stocks have seen very significant appreciation in their share prices such as Venture, Valuetronics, UMS, Elec and Eltek, etc. So in the situation of AEM, what we have is a convergence of three extremely bullish conditions 1. transition from old to new tech cycle, 2. being at the cusp of the new growth cycle, and 3. in the midst of the wider semi-con boom cycle. When the stars align in such a way, what you get is an explosive growth in profits mixed with a low P/E market valuation due to having only recently exited the previous tech bust cycle, resulting in an explosion in share price.
At present, the first condition is no longer true, as the market valuation of P/E is no longer as undervalued as before and the 'turnaround' aspect is gone. However, the second and third conditions - AEM being at the start of its growth phase as well as participating in a wider, semi-con boom - still apply, which is why I have confidence that there is still plenty of room for its profits to run up. Furthermore, even having multiplied nine-fold in share price, I believe its forward P/E is still relatively undervalued, being below 10, even if we only use the most conservative profit guidance given by the management.
2. Federal Int (2000) (25% of my portfolio)
The next position in my portfolio is Fed Int, an Indonesia-based supplier of products and services to the oil and gas industry. The first thing to note is that its trailing P/E is 9.21, with a dividend yield of 3.6%. At such a market valuation, it is clear that the market has not yet priced in any future growth prospects, and is mostly pricing the share based on its recent revenue/profit results. Unlike AEM, which is early past the starting line of its growth phase, Federal Int has not yet begun to run. This means the entire move is still there to be absorbed.
The growth story of Fed Int lies with its MOUs and strategic partnerships with companies that have the financial muscle to bid for oil and gas projects in Indonesia that it has only recently acquired. Indeed, the first solid announcement of a major project was announced only on May 17 where "The parties are in advanced discussions with the owner of the LNG terminal project and the proposal is to be submitted directly to the owner of the LNG terminal project." and is "estimated to cost about USD 260 million and will take about 24 months to complete." Federal Int's current market cap is 58.4m SGD with a FY 2016 revenue of 89.4m SGD, so a 260m USD contract, even though the revenue will be spread between Fed Int and its partner over a period of 2 years, is likely to still be a very significant addition to revenue and earnings. Furthermore, "Under the MOU, COOEC (the other party) shall provide the financing for the construction.", meaning this additional source of revenue comes at very little capex or financial risk to Fed Int.
Having swung around in limbo after oil prices crashed, the new rash of MOUs and strategic partnerships promise a series of acquisitions of major projects to be obtained when its partners successfully bid for projects. These new potential projects will in turn propel Federal Int into a new boom cycle.
Furthermore, there is the presence of other positive macro-cycles. In the first quarter report, the CEO/Chairman remarked that "As Indonesia plans up to US$ 200 billion of investment in order to increase output at its oil and gas fields and expand refining capacity, this is a particularly exciting time for Indonesian offshore marine contractors.”. Certainly, Indonesia's rapidly developing economy will require additional demand for cheap energy.
Finally, we can consider the general macro-cycle of the oil and gas commodities. The O&G sector has been experiencing severe challenges ever since oil prices crashed from $100 to $50. At the current price, oil is unlikely to significantly dip further as oil-producing nations recognize the necessity of stabilising oil prices to protect their own revenue and profit margins. The industry in general has become very cautious due to the challenging conditions present, which makes over-supply in the near-future unlikely. Despite these near rock-bottom conditions, Federal Int has managed to survive and remain minimally profitable. By itself, this indicates an able management that has managed to keep the company afloat through bad times whilst positioning the company to thrive when the dawn of opportunity arrives. With Fed Int managing to stay profitable in the most trying of conditions, the risk-reward balance significantly favors Fed Int as the risk of oil prices further declining is minimal (due to reasons stated above) whilst the potential upside should oil prices improve is tremendous.
Obviously, partnerships and MOUs are insufficient indicators of Federal Int moving into a new boom cycle. However, what is incredibly compelling is the rampant insider share purchase that has gone on in recent months. These insider share purchases are not company share buybacks, where the company uses its own money to buy back its own shares, but are in fact individual insiders buying up large sums of shares with their own personal money at current prices! Very often, this is the defining indicator of a company that is poised to do extremely well in the near-future. They are putting huge amounts of skin in the game, betting significant money that the company will do well based on insider knowledge.
Unfortunately, there is almost nothing available to forecast their potential earnings growth, as no major projects have actually begun. On one hand, this means that most of the market will stay on the sidelines, waiting for earnings growth to show up before putting their money in. On the other, this means that because the market is staying out, those with a bigger risk-appetite can enter at what the insiders believe to be extremely good prices.
So despite having almost no indication of the potential profit upside, I still consider Fed Int to be a worthwhile stock to invest in because 1. quality management has brought the company through during trying conditions, 2. its available at a market valuation that has not factored in future growth, 3. strong indicators of profit growth via MOU, strategic partnerships, contract announcements, 4. insider share purchases at current prices all converge to suggest a stock that is of low-risk to enter, with a potentially enormous upside should major contracts be acquired, and even further upside should oil prices rise.
3. Excelpoint (55% of portfolio)
Finally, my final, biggest position is in Excelpoint. Its my biggest position because it combines 1. a turnaround situation resulting in a undervalued market valuation, 2. a growth stock, 3. a macro boom cycle in the semicon/electronics industry, 4. a clear, huge upside, 5. quality management that has demonstrated resilience in trying times and confidence and aggression in growing shareholder value, 6. consistent, significant dividend payouts of 50% of earnings.
Since 2011, Excelpoint, an electronics distributor, has been borrowing heavily in order to grow its revenue and earnings. It did so with much success until 2014, where challenging macro-conditions in China (China's economy encountered difficulties in the late 2014s and 2015) bled its profit margins which only recovered in the second half of 2016. It underwent a cyclical downturn, a moderate 'bust' cycle, and came out unscathed as its revenue continued growing despite reduced profits. To be clear, its revenue doubled from 498m USD in 2011 to 988m USD in 2016, increasing by roughly 100million every year. If not for the weak first half in 2016, I believe its net profits would similarly have doubled from 4.7m to 9.4m (actual FY 2016 profit was 7m).
Because its profit margins were depressed from 2014 to early 2016, despite a rapidly growing revenue, its net profits suffered which in turn forced down share prices. However, the depression in profit margins was clearly cyclical in nature, as the huge recovery in profit margins in 3Q2016, 4Q2016 and 1Q2017 demonstrated. The market has yet to fully appreciate this situation, providing the explosive set-up of a turnaround + growth stock combination where one is able to buy a fundamentally undervalued stock in addition to excellent growth potential.
The quality and confidence of its management was demonstrated during the major bust cycle during the 2008 financial crisis which severely impacted the operating environment of Excelpoint. Because of the severe downturn in consumer confidence and business sentiment, Excelpoint suffered losses in 2008 and 2009, during which the management sensibly streamlined its operations, stopped dividend payouts, and reduced debt liabilities. As consumer sentiment improved, Excelpoint managed to turn profitable in 2010, and immediately began borrowing to expand its operations again. A positive operating environment enabled Excelpoint to further grow profits and revenue from 2011 to 2013 until it encountered another cyclical downturn, this time of a more moderate nature. From 2014 to 2016, despite reduced profits, the management continued to aggressively borrow and expand, enabling it to reap the rewards when the cycle turned upwards in 2016. The proactive aggressiveness and confidence of the management to successfully grow its operations through debt, as well as decisive navigation through challenging times, gives me great confidence in the management.
Because its profit margins have been rather consistent and well-established, I have managed to map out a clear expected upside where I expect the share price to hit at least 1.2 by November 2017. For more details on how i reached my target price, check out my posts on the Excelpoint page.
Furthermore, I expect Excelpoint to ride on the boom cycle of the semicon/electronics sector.
Finally, it has consistently given out 50% of its earnings as dividends, which is simply superb for shareholder value and confidence. Many market participants highly value dividend payouts, and this will surely attract attention from these players.
The only sore spot of Excelpoint is its negative cash flow and high debt. I have written more about it in my other posts on Excelpoint. In short, due to the thin profit margins in its industry, Excelpoint has to rely on debt to grow because the profits earned are simply too little (it profits range from 4 to 7m from 2011 to 2016 whilst its revenue has grown by 100m every year). Furthermore, its EBITDA/ Interest expense ratio is very healthy and the management has displayed great skill in managing its debt successfully for a long period of time.
In conclusion, Excelpoint hits every fundamental criteria I demand. 1. Its current market valuation now is a trailing P/E of 7 with a dividend yield of 3.76%, but my own estimated forward P/E based on the current market cap is 5.2 with a projected dividend yield of 10%. 2. it has a very respectable, sustainable CAGR of 15% over the last 6 years, 3. it has just exited a bust-cycle and is riding on a macro-boom cycle in semi-con/electronics, 4. great management with the chairman/ceo with plenty of skin in the game (49% of shares), 5. with a clear upside. For some, its borrowings/cashflow is a problem but for me, it is a testament to the quality of the management.