There’s A Business Behind Every Stock

If I were to ask you to bet your money on the future success of your investment in a property company, whom would you choose to become the CEO of your company, Dato’ Liew Kee Sin of Eco World Development Berhad or your good friend Datuk Bill Ch'ng Chong Poh of Malaysia Pacific Corporation?

If I can trust your IQ, betting on the most capable person would make greater sense for you than betting on your good friend.

The same philosophy holds true while investing in stocks. You must not put your money on a stock whose name you like the most or whose chairman is your good friend. Instead, you must invest in the stock of a business you believe has the maximum potential.

But this is one reality that most investors forget – that…

“… a stock is not just a piece of paper that has a name, but a share of a business that has real assets and profits.”

While buying a stock, you should take the same approach as you would if you were buying an entire business. The only difference is that instead of buying the whole of the business, or a partnership in the business, you are only buying a tiny share.

“Investing is most intelligent when it is most businesslike,” Ben Graham.

The idea of buying a stock without understanding the company’s operating functions – its products and services, management quality, employee relations, raw material sources and expenses, plant and equipment, capital reinvestment requirements, and needs for working capital – is unacceptable.

This mentality reflects the attitude of a business owner as opposed to a stock owner, and is the only mentality an investor should have. Owners of stocks who perceive that they merely own a piece of paper are far removed from the company’s financial statements.

They behave as if the stock market’s ever-changing price is a more accurate reflection of their stock’s value than the business’s balance sheet, income statement, and cash flows.

For Buffett and all other successful investors , the activities of a stock owner and a business owner are closely connected. Both should look at ownership of a business in the same way.

 “I am a better investor because I am a businessman and a better businessman because I am an investor.” Warren Buffett

As explained in ‘The Warren Buffett Way’ by Robert Hagstrom, these are some of the key questions that you must answer to understand the business of a company.

Questions you must answer to understand a company’s business

Let’s discuss them in some detail here.

Questions on the core business

1. Is the business simple and understandable?

Never invest in a business you do not understand, for you can’t see the future opportunities and challenges before they arise. For example avoid special-purpose acquisition company (SPAC) if you don’t know how shell or blank-check companies that have no operations but just with a famous person can beat all other smart investors and established companies in the world to acquire great businesses and make big fortune for you.

“Acknowledging what you don't know is the dawning of wisdom.” Charlie Munger

2. Does the business have a consistent operating history?
Past performance is no guarantee for future success, but it shows if a business can operate under varying business conditions. Very often, that is the only thing we can rely on. Often naïve investors try invest beaten down stocks of companies with poor and untrustworthy management with the hope of turnaround of the business and hence its share price. Alas with the same management which has shown poor operating and management record, the turnover never does. As Buffet says:

“In the business world, the rear-view mirror is always clearer than the windshield.”

3. Does the business have favourable long term prospects?

‘Sustainable business’ is the key word here. Look for business that would most likely to last for many years to come. Stay away from companies that operate on trends and fads that can go out-dated in the future.  Yes, like APACs.

Questions on management quality

4. Is management rational?

Now this is a very important part of an investor’s business analysis. The rationality of the management and its ability to deploy cash in a profitable manner is what separates a good business from a bad one.

• Stay away from companies with ambition of empire building rather than focus on the efficiency of the core business.
• Do not invest in companies which the CEOs know only how to talk c*** but care nothing about the running of the business.
• Avoid with all cost companies with CEOs who are very good in speculating in shares.

5. Is management candid (frank) with its shareholders?

You don’t want to get into a future Enron, right? Look for managers that admit mistakes and take complete responsibility of their actions, rather than blaming everybody, and macroeconomic and political events and everything else.

6. Does management resist the institutional imperative?

Institutional imperative is the need for managers to act like their peers, no matter how irrational their actions may seem. Avoid managers who have the tendency to give in to peer pressure and do dumb things.

Questions on financial performance

7. What is the return on equity?

As we will understand later, return on equity is one of the most important metric for evaluating the profitability of companies. Earnings can be manipulated, but return on equity will show how worthy a business is.

Intuitively, if you put in RM100,000 capital into a business, are you looking at what earning the business makes, what are the margins, or are you more concern about the return of your capital?

Long term, return on equity will have a more profound effect on the company’s fortune than earnings.

My personal preference is Return of Invested Capitals though, but the principle is the same.

8. What are the profit margins?

A company that can convert its sales into profits is a successful business. The key is to keep costs at the minimum, and go for higher profits instead of higher market share. Avoid companies with low margins relative to its industry.

Finally, remember what Buffett said:

“If a business does well, the stock eventually follows.”

And don’t forget what Peter Lynch said too.

“ Wonderful companies become risky when people overpay for them.”

Hence you must have a good feel of the value of a company in order to avoid overpaying for a business.

By,

K C Chong (15 May 2014)

How To Win At A Winning Game

IN our last article, we showed that the rewards of staying invested in equities for the long term are tremendous. But the fact is a lot of investors in equities ended up losing money.

Consider the track record of Peter Lynch who managed Fidelity’s Magellan Fund from 1977 to 1990. He beat the S&P 500 Index in all but two of those years and averaged returns of 29% a year.

That’s mind-blowing. It means that US$1 grew to more than US$27. Had you invested as little as US$37,000 with him in 1977, you would have been a millionaire in 1990.

You would imagine that most of the investors who put money in the fund had made money. But guess what? Lynch himself once said he believed more than half the unit-holders in his fund had lost money. It depended on when they had bought and sold Magellan.

Morningstar, a mutual fund research organisation, conducted a study to track the cash flows in and out of the United States’ leading growth funds in the 90s.

The contrast between the returns of the funds themselves and the returns of the investors was absolutely breathtaking: The 219 growth funds averaged an annual compounded return of 12.5% for the five years ended June 1994.

But the investors did much worse. They apparently didn’t make any money at all; instead, they lost 2.2% a year with the same group of growth funds.

Both of these findings point to the same conclusion, that is – as a group, investors do a rather poor job of deciding when to buy or sell their investment funds.

Chart 1 shows the movement of the Dow Jones Industrial Index in the US in the last ten years. A typical inexperienced investor will probably behave as below:

July 2005: The market has been quite steady and trending up for the past 2½ years. All the market experts are saying that prices will continue to go up. Ok, I’ll invest US$10,000 to test the water first.

April 2006: The US$10,000 I invested is now worth US$10,682. That’s a return of close to 7% in one year. Not bad. Market looks firm. I think I’ll invest another US$50,000.

May 2007: My capital of US$60,000 invested so far is worth US$72,750. Wow, this definitely beats leaving my cash in the bank. Ok, I’ll transfer US$100,000 more from my fixed deposit and invest in the market.

January 2008: What’s all this news about the sub-prime market? Market is choppy. But it’s ok, these investments are for the long term.

January 2009: Oh no! There doesn’t seem to be a bottom to the market. Now people are talking about the possibility of another Great Depression. During the Great Depression, the Dow Jones fell from a high of 386.17 on Sept 3, 1929 to a low of 40.56 on July 8, 1932. That’s a plunge of some 90%. The market did not recover to the 1929 levels until 1954, some 25 years later! Now my portfolio is down by 37% only. I better take out what I have left.

So the investor exited the market in January 2009, and got back US$101,422 of the original US$160,000 invested. As it turned out, the investor withdrew his or her money near the bottom of the market. Two months later, in March 2009, the market rebounded sharply.

The thing is, if the investor had stayed invested and held on to his or her shares, their US$160,000 would have been worth close to US$200,000 by now (early 2014). All the numbers above exclude transaction costs and dividends.

Because of this emotional tug of war between greed and fear, many investors effectively manage to lose at a winning game.

So how exactly do we ensure that we win at this winning game?

First, understand that when you invest in a diversified basket of stocks, you are investing in a slice of the economy. As long as we need to buy and sell things – there is no question about this here because we can’t possibly produce all the things we need ourselves – then there will always be a value to productive companies.

Second, don’t exit the market when everyone is rushing for the exit at the same time. Then, you will not get a fair value for the businesses that you own.

Third, all the more, you should buy when you see businesses going on sale at a cheap price.

Now let’s see how someone would have done if he or she had kept investing in the stock market through the Great Depression. We know that the Dow did not recover to the levels reached in 1929 until some 25 years later. The Great Depression was the worst period the stock markets had ever gone through – it was way worse than the Asian Financial Crisis and the more recent Global Financial Crisis. So did an investor who put money into the market during the most adverse of market conditions see zero or even negative return?

The chart below shows an investor, let’s call her Mary, who started investing in the US market in early 1926. She put US$100 into the market every year. Her investment did well in the first four years. Then the crash of October 1929 happened, to be followed by the Great Depression. From a high of 381.17 points on Sept 3, 1929, the Dow fell to a low of 40.56 on July 8, 1932. That was a plunge of some 90%! But Mary kept faith. She believed in the continued functioning of the modern economy, that is, as long as companies are allowed to produce what people want and need, they will make money. So she kept investing US$100 into the market every year.

By the end of 1950, Mary would have put US$2,500 into the market. Her portfolio value as at December 1950 was at US$4,342. This despite the Dow Jones Index still being 38% below its peak in September 1929.

Mary managed to grow her capital by 4% a year by consistently putting money into the stock market even through the worst of times. She managed to beat the inflation rate of 1.3% during that 25-year period. In other words, she generated for herself a real return of 2.7% a year in the most adverse of situations! This excluded the dividends she would have received from her portfolio over the years.

So to recap, the secret to winning in a winning game is:

One, consistently invest in a diversified basket of stocks that represents the real economy over the long term;

Two, don’t bail out at the worst of times. All the more, if you can afford it, put in more money at the most depressed of market conditions.

Keeping to these two golden rules will ensure that your savings will grow faster than inflation, and that you will tremendously increase your odds of meeting your financial goals.

Source: The Star