Value investing for long-term

Why is value investing good for the long-term? The main reason is due to the theory of “reversion back to the norm”. Something that is undervalued won’t stay as such for the long-term. As the market catches up, the undervalued stocks will catch up as “investors” (or traders in this instance) look for new stocks that hasn’t risen that much or has stayed beaten down for some time. Market will always re-value companies that are fundamentally strong, higher.

A current example I can think of is that property investors investing in Hong Kong and Singapore are heading to Tokyo to invest as prices are still cheaper there. After a while into the future, properties in Tokyo will become expensive too as more investors jump on the bandwagon and brings prices up (reversion back to the norm).

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Putting net profit margins into perspective

The profit margin tells you how much profit a company makes for every $1 it generates in revenue. For example, if the net profit margin is 30%, company makes $0.30 for every dollar generated in revenue. It is calculated by using:
(Net income ÷ Revenue) * 100%
Personally, I look for net profit margins to be higher than 20% (exceptions made for certain companies for underlying reasons).
Always compare the net profit margin with that of similar companies. Comparing margins with peer group provides an excellent way of judging performance of the management team. If the margin of a particular company is always consistently higher than those of similar companies operating in the same sector, then as a business and as a management, the company has found a winning formula. The higher-margin business has built up a dominant market position, effective way of generating high margins and a culture that enables it to do very well in the long run.

What has been driving the company’s margins?

It is imperative to understand what forces have been driving the company’s high margins. This will affect the sustainability of such margins and potential risks. For example, if margins have risen due to a temporary price increase in a volatile commodity, the higher margins will prove to be transitory and margins will reverse when prices decline.

Similarly, temporary boosts to margins from lower raw material costs are likely to unwind relatively quickly and it owes nothing to prudent management. However, a sustained effort by management to improve and source for more cost-effective/higher quality components is likely to offer longer term benefits.

If margins are boosted by solid volume growth, good pricing, new product developments and improved product quality, then it’s good. Not only margin expands but the company’s position and profile in the market will be boosted.

If margins are slim, is there any risk of going into a loss?

Low margins can mean significant risks as there is little chance for anything to go wrong. If margins are low due to things already going wrong, it may not take a lot to see profits swinging into losses. For example, a contractor with net profit margin of 1% may run into problems with a large contract and quickly see losses.

The risks are substantially higher if the business is highly volatile and subject to wide swings in volume and pricing.

If margins are a lot higher than that of competitors’, can the figures be believed?

Margins that are significantly greater than the competitors should be closely looked into. They may genuinely represent superior efforts from management – better products produced at a much lower cost. However, such margins can also reflect a less prudent approach to accounting – low depreciation charges, recognizing profit earlier than sensible. Henceforth, it is well worth being aware of any accounting issues that are flattering net profit margins.

Similarly, if a company is generating high margins for producing a basic commodity, scrutinize the basis for high margins.

Putting P/E ratio into perspective

A low P/E ratio doesn’t necessarily mean that the company is undervalued and is a prospective buy. On the other hand, a high P/E ratio also doesn’t mean that the company is overvalued and we should chuck it aside.

A company with low P/E ratio may not mean that it is attractive (or undervalued) due to the following reasons:

  • company has uncertainty over its prospects for earnings
  • company is operating in a highly cyclical sector
  • company is serving volatile markets
  • company is operating in a sector with overcapacity and weak pricing power
  • company is operating in a sector with low returns consistently
  • company operating in a mature sector, with little prospect for growth
  • company is ex growth
  • company has poor management with no convincing strategy for growth
  • company has poor cash generation
  • company has a weak balance sheet

Whereas a company with a high P/E ratio may not mean that it is overvalued due to the following reasons:

  • company has an excellent growth record and prospects for growth
  • company is operating in a high-growth sector
  • there’s high confidence in company’s forecasts
  • predictable/stable returns
  • strong market share
  • high barriers to entry
  • strong pricing power
  • high margins and excellent returns
  • superior management with excellent growth strategies in place
  • strong cash generation
  • strong balance sheet

P/E ratios also have advantages and disadvantages.

Advantages of P/E ratio:

  • easy to compute
  • widely used so it’s easy to find a company’s P/E ratio
  • takes forecasts into account
  • earnings is a measure of what is generated for shareholders

Disadvantages of P/E:

  • does not take debt/financial structure of company into account
  • gearing up/share buy-backs increase earnings (‘financial engineering’)
  • earnings are prone to manipulation by management
  • does not take cash generation into account
  • presents difficulties in assessing quality of earnings

Thus, P/E ratios must always be compared with companies of the same sector and with the overall market P/E. Various matrices must be looked at (not only P/E ratio) before investing in a company as well.

Singapore’s future growth sectors

2010 is coming to an end in less than a month’s time. What are some of the future growth growth sectors for Singapore going forward into 2011? The sectors I’m bullish on are:

  • Tourism – hotels, gaming, medical tourism, shopping centres
  • MICE
  • Transport – Land and air
  • Construction
  • Financial
  • Property
  • Luxury goods
  • Offshore marine
  • Commodities

I particularly like the tourism sector and the sectors related to tourism. Tourism is going to be a major future catalyst going forward with the IRs bringing in so much good fortune. With the high net worth individuals (HNWI) setting up shop in Singapore, property, financial and luxury goods are set to do well and the aforementioned sectors are also related to tourism.

Macro Investing vs Micro Investing

There are basically two ways an investor can research into which stocks to buy. One is looking at the macro picture (macro economy) and zooming into a particular industry and stock. The other is looking at the stocks itself and then panning out to the industry and the economy as a whole.The former is called macro-investing and the latter is called micro-investing.

An example of macro investing would be this. With the advent of the IRs, I believe that tourism and the industries related to it is set to do well. So, I look at the industries and stocks related to this. Hotel occupancy rate will boom and especially the hotels situated near the IRs will do better. Then, I look at which are the hotels near the IRs and if they are listed, I may choose to invest in them. Another industry that is set to do well with the influx of tourists and the mega-rich will be the property market. After determining a particular company that is set to grow, the investor can look into the financials and decide whether to invest in it. This is also called the top-down approach.

On the other hand, micro investing involves looking at a particular company first. Let’s use the company SIAEC for this example. I look into SIAEC and if I like the financials, I decide whether there is growth for the company in the macro perspective.  Air travel is picking up and people have started to have confidence in the economy. Thus, SIAEC might be a good company to go into. Another name for this type of analysis is the bottom-up approach.

There’s no right or wrong way, just individual preferences. As for me, I use both the top-down and bottom-up approaches. I used to use the bottom-up approach more. I look at the company’s financials first and determine if there is growth for the company with the economy as a whole. Now, I have incorporated the top-down approach to my investing arsenal as well. I use this approach when looking at which industries and companies are set to do well for the future. These companies should be able to ride the Singapore growth story well. This habit was cultivated after talking to and learning from my uncle, who is more of a top-down investor.

Do keep a lookout for my upcoming post on the growth drivers of Singapore for the next few years…

P/E ratio of STI

The P/E ratio of STI is currently at 12.42. One can obtain the P/E ratio from either Business Times Weekend edition or Bloomberg (need to create account for this).

STI is currently undervalued according to P/E ratio. I have included a historical P/E ratio chart as below as well.

Kingsmen in China

Yesterday, I came across an article on Pico, a company which is in the same industry as Kingsmen. The article was an interview with the chairman of Pico. I read the article to know more about the industry and to learn more about Kingsmen’s competitors.

After reading the article, I realised that Pico has a strong footing in China, the region where Kingsmen is looking to get a better footing in. In the article, it says that “The current breakdown by geographical segment for Pico is 60% from Greater China and 40% from the rest of the world, with India set to be the next growth driver.” For Kingsmen, it’s almost the other way around. For FY2009, Singapore brought in 60.3% of the revenues for Kingsmen vs China’s 18.5%. However, Kingsmen is more into interiors than exhibitions (a segment Pico is more involved in and this brings in bulk of the revenues). All the while, the interiors segment has been bringing in most of the revenues for Kingsmen except in FY2009. I believe in FY2009, exhibitions and museums brought in the bulk of revenues than interiors segment due to the Universal Studio Singapore project.

The question now is, going forward, will Kingsmen be affected by competition in China, especially from Pico since it’s well-established in China? We know Kingsmen is expanding its business in China as there are lots of potential in that region.

I believe Kingsmen will do well going into China. Reasons being, Kingsmen is well-established and is reputable, it has competent management (seen from the financials, work done and informal chat with the GM), strong cash positions and repeat customers. Brands based in Singapore expanding into China and who have been engaging Kingsmen all these while, will continue to do so when they expand into China. A great example of this would be F J Benjamin. It is going to expand its Raoul stores to China and I’m sure it will continue to engage Kingsmen because of good rapport. Working with F J Benjamin will be perfect for Kingsmen to be recognized by local Chinese retailers and this could be a catalyst for further projects in China.

On a side note, after reading the article on Pico, I emailed the General Manager of Kingsmen (met him during Invest Fair 2010 with a group of shareholders) to know his thoughts about the Chinese market. I surprisingly got a reply (shows management is willing to entertain minority shareholders like me) from him. I will reproduce the email below.

I sent:

Dear Mr Cheng,

I saw you during Invest Fair this year and I’m vested in Kingsmen. I like Kingsmen for its strong cash position, good cash flow and branding.

I would like to ask a question from a shareholder point-of-view. Recently, Kingsmen raised its equity into the China market through Kingsmen (Noth Asia) Limited and currently holds 92.2% of it. Kingsmen is looking to gain a better foothold in China from the looks of it.

How keen is the competition in China and will the profits be streaming in well, considering Pico is already quite well-established in China? I came across an article on Pico at http://www.nextinsight.net/index.php?option=com_content&view=article&id=3273&Itemid=1 and it shows how dominant Pico already is in China. How is Kingsmen going to better Pico to gain a footing in China?

Looking forward to your reply. Thank you.

Mr Cheng’s reply:

Hi

Nice to hear from you.   Yes, China will be one of the Group’s growth engines going forward and we will be committing more resources to grow that market. We have already been in the China market for over 10 years now but we have only scratched the surface in addressing that market. Significantly, the global economic shift has also made it necessary for us to push harder into China as many our existing clients as well as new global brands are looking to China for growth and they have a need our services there. Our markets strategy in China also be to focus on the mid to high end segment and brands – and therefore competing in a different arena from our traditional competitors – who are more focused on the exhibitions and events space.

Best regards

Andrew