How does an ordinary investor can do well with value investing? First, you must understand the true meaning behind of buying a stock. It is not just holding on a paper, but it is a business that you are investing in. All you need to do is spend some time reading the annual report and understand the business.
Below is guidance on how to make a good investment:
i. Business Growing Potential:
How fast is the business growing? Is it sustainable? You have to find out the answer and check out whether the story is true. A simple rule of thumb of at least 15% annual growth rate is a good investment. However, you have to be cautious with business that is growing at more than 30% annually. There are not many company are able to maintain that kind of growth rate!
ii. Return on Shareholder Equity (ROE)
How to calculate ROE? Take the year net income and divided by average of 2 years shareholder equity. ROE is used as a measure of how fast the business returns to existing shareholder equity. An average ROE of above 15% is a good business, but you have to look carefully into the company balance sheet and understand why the business can command such a high ROE. Some of companies are able to maintain high ROE by constantly paying out 60% to 90% of net income as dividend. As a result, the shareholder equity is increasing at very slow rate and the net income is not increasing faster either. Therefore, ROE will be able to maintain at previous rate, as long as net income is not decreasing! This scenario happens to most of the cash cow company where the business is at mature stage and the growth is very slow. There is another scenario where business is taking excess leverage to maintain the ROE. In this case, you might want to check out the debt level of the business. Are they increasing over the year? Most of the property & commodity business is growing by leverage.
The best case is having a high ROE by maintaining high net margin with less leverage.
iii. Pricing Power
A business which can control the selling price without facing deteriorating demand is a fantastic business to invest in. For example, food, beverage & glove maker business is a fantastic business to invest in, as the demand is in-elastic. Both of them are able to pass on extra cost due to inflation without slowing down the demand. There is many more business like this. You may be had noticed that if you are shopping in NTUC or any retail mart. Most of them are boring business but it is essential of human daily living!
iv. Superior Management
You might want to know who is running the business. A good management team is definitely a plus. There are many ways to check. First, read on the annual report and understand what are the messages from CEO and Chairman are trying to deliver. Are the messages very fancy or more like prepared speech by PR? You might want to look out for a decent tone. A good management team will try to feed more info of the business, rather than trying to hide some details from investor. Second, you also can check with the company employee and dig more info from them. In this case, you might want to talk to the manager, as they have more info on company policy and management capability. The last thing you can do is attend the annual general meeting and talk to the management yourself.
v. Strong Corporate Finance
Good company always comes with strong corporate finance policy. A chairman should be an independent candidate and have strong background of related business experience. An audit and remuneration committee should not have any of the executive directors inside! ESOS (Employee Share Option Share) is a way to reward the hardworking employee. However, excess issuing of ESOS with low exercise price is a disaster! This will dilute the existing shareholder value. The rule of thumb is ESOS should not more than 1% of existing common share.
Sunday, April 26, 2009
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1 comments:
I find that the best indication of how undervalued a stock is is the price to sales ratio or what is commonly referred to as market cap.
Simply stated. If a company does 1 billion in annual sales but it has a market cap of 100 million dollars than the price to sales ratio is ten to one. In other words the market is valuing a company that does 1 billion dollars in annual sales at just 100 million dollars. But what does this mean. It means everything if you are a classic value investor.
Here is a perfect example of why the price to sales ratio is so very important if you are a value investor in stocks. If our 1 billion dollar company is breaking even that is they are not making a profit nor losing money. Lets say the company has 250 millon dollars in long term debt and 80 million dollars in cash. We will say they are in the food business they make a wide aray of food products. Maybe the company did a buyout of another company a few years ago that did not work out as well as expected. So thats why the company is having trouble making a profit but things now seem to be moving in the right direction. If I purchase shares in the company for say 10 dollars. And over a five year period the company improves their earnings performance to the point where their now earning say 60 million dollars on sales of one billion two hundred million dollars. Thats a profit margain of 5%. If the stock were to now trade at twenty times earnings that would now mean that the price of the stock would be at 120 dollars a share or another way to put it the marketcap is now one billion two hundred million instead of 100 million.
The problem for me is not that this investment method is not effective it works great. I purchased seaboard stock back in 2000. I think it was for 190 dollars a share around that. I following the exact method I describe above. I sold my shares about five years later for 2500 dollars yes thats correct 2500 dollars or more than twelve times what I paid for the shares. Seaboard was profitable when I bought it and profitable when I sold it. The stock was just a great undervalued stock that was overlooked by investors.
Like I was saying before the problem is not with this investment method. Its that stocks like seaboard are very rare indeed theirs just not a whole lot of quality companies out their selling a very low price to sales ratios. Another issue that I have been having is when a company of decent quality trades at a very low price to sales ratio its not long before a private equity firm or the family of a family owned company takes notice and usually makes a low bid for the shares and takes the company private preventing me from realizing the enormous gains that mght have been possible had I not been forced to sell my shares out to a party that was making a very unfairly low offer for the shares of the company.
Another thing to keep in mind when it comes to value stocks that have a low price to sales ratio that could give the buyer a tremendous advantage is this.
I mentioned earlier that are food company had 80 million dollars of cash on their balance sheet now if the company choose to they could buy back a large chunk of their stock maybe 30 million dollars worth of the shares outstanding it would only cost them 30 million dollars they still would have 50 million dollars of cash left on their balance sheet. This means that under the positive earnings outlook for the company the stock price could even be much higher than 120 dollars a share. If the company were to retire a large percentage of their exsisting shares in a stock buyback.
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