Month: May 2010

The economy works in a predictable cycle…

The previous post reminded me of something. My uncle once sent me a chain email about the economy and its predictability. When I first read it around 3 years ago, I didn’t really connect with the message. Now, the email makes total sense. Read the email reproduced keeping in mind what happened over the past 1 – 2 years.

“The economy works in a predictable cycle. Let’s start from the end of a depression. When the market revives from a depression, stock prices will be the first thing that climbs up. Then, all kinds of interest rates will increase. This is followed by a drop in unemployment rate and companies posting good annual report. Stock prices begin to skyrocket and everyone starts to talk about how much they make in stocks. Those who have earned enough from the stock market will start to pump their money into properties. Property hype begins. Property prices shoot up. Interest rates continue to increase. Salaries increase. Economy is now in a boom.

During economic boom, more money is channeled into properties. Property prices continue to rise. Stock prices begin to stagnate due to lack of fund. Interest rate and rental rise to an all-time-high, businesses manage to survive because consumers’ spending is still high. Consumers’ spending is high because of good salaries, good bonus and good earning from stocks. Usually when this happens, some bad news will set in and the market crashes. Stock prices fall sharply. Money in the market suddenly dries up because everyone withdraw their money out of fear. Economy begins to slow down. Rental falls, property prices begin to fall. Everyone starts to tighten their spending, resulting in poor business for every company. Business is bad, unemployment increases. The economy is now in a depression.

During economic depression, businesses with poor business model or poor products will be phased out. Interest rate starts to drop to help businesses to survive. The market begins its correction process. After the correction, the economy cycle repeats. Stock market will be the first indication, followed by interest rate, and finally property. The rich understands this economic cycle. Unlike the poor, the rich will start to park their cash in the stock market towards the end of the depression. The rich will wait patiently for 1, 2 or 3 years. They are not bothered by the daily fluctuation in stock prices. When stock market revive, they easily make 200-300% return. The next thing they watch out for is the property prices. When property prices begin to show its first quarter increase, they will sell off some of their shares and grab a few properties. In another 1 or 2 years, their properties appreciate in value and they easily make a few millions. When the economy reaches its peak, they will sell off some of their properties, keep some to earn rental income and park the rest of their money in fix deposit, survive through the depression (which can last for about 5 years!) and wait for the next cycle! Guess what the poor will be doing? They do the exact opposite. When the market is good, they got their pay rise and bonuses. They feel rich and start to think of some investment. Usually, they will turn to a bank and listen to those unit trust managers who show them all kinds of track record about the superb performance of their unit trusts. The poor will then put their hard-earned cash into those unit trusts and become a victim of the next economy depression.

I hope you know where your economy is at right now. In Singapore, property hype has just began. Property prices are increasing at astonishing rate and it’s getting harder to find good investment. Economic boom may continue for another 1-2 years (that’s my guess), but the days of getting 100% return in stock market is gone. Property investment is still viable, but 100-200% return is not likely. For those who have just started work, this round of economic boom is not for you. You should use the next 5-7 years to accumulate your cash and get ready for the next boom. Remember, history repeats itself. You don’t have to be a swami guru to predict the future.”

Remember the email message was from 3 years ago. So the last paragraph doesn’t represent the current situation. Where are we right now? We might be in the slow recovery phase as the US interest rate is still very low and have remain unchanged.  And look at the bolded phrase in the message, “the rich are not bothered by the daily fluctuations”. If you have a long-term outlook, then the short-term volatility is actually an opportunity for you to get stocks at a sale. And the stock price always goes to its true value in the long-term. This brings me to a Benjamin Graham quote. He once said, “In the short-term, the stock market behaves like a voting machine, but in the long-term it acts like a weighing machine”.

Oh no! The markets are down!

Recently, the market has come down quite a lot mainly due to the European debt crisis. What are investors to do? A) Sell all your stocks, even at a loss B) Hold on to your stocks as they are fundamentally strong and average down when the opportunity arises C) Sit in a corner and pray hard Personally, I would choose B. By investing in companies that are undervalued and fundamentally strong, it doesn’t really matter what the market is doing during the short-term. In the long run, the true value of the company will be reached provided its fundamentally sound. Also, by value investing, we have a target at where we would like to sell it. This makes us grounded whenever there is short term volatility. Better still, if the price of the good company comes down further, we can average down. That’s why it’s wise to always keep cash in hand to seize the opportunity that the market presents. However, if you are fully invested, just wait by the sidelines as the market always realizes the potential of a solid company. Remember Warren Buffett’s quote: “Be fearful when others are greedy and be greedy when others are fearful”? It’s time to be greedy now when the market is in apprehension. If you have bought ETFs of the indexes, it may be wiser to liquidate your positions and sweep your profits off the table. The indexes have broken down past their weekly 20-day moving average and may see further downside as the charts show a downtrend channel. However, if you are sitting at losses, you may want to hang on to them as the markets are at fair value now anyway. If the market goes down further, you can always dollar cost average (DCA). Whenever there’s a crash or financial crisis like in Oct 2008, always remember that “this too will pass”. During crashes, people who take the opportunity emerge victorious at the end of it. If you had bought strong blue-chip companies like SGX, SPH, Capitaland during the crisis in 2008-2009, you would have seen huge percentage gains on your portfolio. Just for example, SGX was around $4 in March 2009. Today, its closing was at $7.35. You do the math. Historically, crashes happen every 6 to 8 years and the market always recovers after it. Will you be prepared when the next crash occurs? You better be if you want to emerge victorious…

What to look out for when investing in a company?

Under the “What is value investing” post, the 1st step to do is to analyse the company fundamentally (both quantitatively and qualitatively) by looking at the financial statements to determine the quantitative part and asking certain questions to determine the qualitative part of the company. The company must also have a wide moat or competitive advantage that will not be breached that easily, if not, at all.  Wide moat can come from the brand name (eg. Coca Cola, McDonalds), monopoly position (eg. SMRT, SGX), pricing advantage, patented technology (eg. Pfizer). Just like in the picture above, the company must be guarded from its competitors with a huge moat. From Wikipedia, a moat is “a deep, broad ditch, either dry or filled with water, that surrounds a castle, building or town, historically to provide it with a preliminary line of defense. In some places moats evolved into more extensive water defenses, including natural or artificial lakes, dams and sluices. In later castles the moat or water defences may be largely ornamental”.

I’m going to do a case study on Thomson Medical Centre (TMC) just so you know how to analyse a company to determine if it’s a good buy. TMC is a near-perfect company (nothing is perfect in this world) that fits the value investing model and I’m happy to have found this gem. After reading this post, I hope you get a clearer understanding on what value investing really is and how to find gems like TMC.

What?

TMC is a leading private hospital in Singapore catering to women and children. Located at Thomson Road, walking distance from Novena Church, it provides a comprehensive range of services with focus in Obstetrics and Gynaecology (O&G) and paediatric services.

Does TMC have a wide moat?

I believe TMC has a wide moat because it has won many awards including being in the top position in Customer Satisfaction Index in the healthcare sector in January 2010 and it was one of the 5 Singapore-listed companies to win the Forbes ‘Asia’s Best 200 Under A Billion’ award in September 2009.

TMC has the highest number of live births among all the private hospitals. It also has VIP rooms and premier wards that makes TMC look like a 5-star hotel. Many celebrities have chosen TMC to deliver their babies. 32.2% of the customers are repeat customers. This shows how much people value TMC and the services provided by TMC. It has become a brand name amongst people.

Now, we will analyse the financial statements.

Quantitative analysis

Revenue and Net Profits

Revenue and net profit has to be increasing throughout the years. The revenue and net profit for TMC have been increasing consistently and the revenue growth rate is at 10.36%. When the revenue and net profit are increasing consistently, we know that the company is strong and most probably will be able to deliver in the future as well. Remember 2008 to 2009 was the financial crisis. However, this crisis did not damper the revenues. This shows that TMC has a defensive business.

Margins

Gross profit margin is above 40% all the way. This shows that for every 1 dollar in revenues, TMC has 40 cents after paying the basic expenses. Not many companies have a high GPM of above 40%. Net profit margin is at 18.87% for FY2009. Even though NPM preferably should be more than 20%, it can be seen that TMC’s has been increasing throughout the years from 12.94 to 18.87% consistently and I’m confident that within 2 years time, it will be above 20%.

Debt and cash in hand

I prefer companies with no debt or negligible debt. Just like how a person aspires to have very little debt, companies with very little debt and a lot of cash do well in times of crisis. TMC’s long term debt (payable after 1 year) is at $1.36 million. Their cash balances is at $9.84 million with $10.73 million in fixed deposits (not shown). From here, it can be seen that TMC is a cash-rich company. Reminds me of the saying “Cash is king”. Their debt/equity ratio is also very low at 0.013.

Ratios

Current ratio is at 1.39. Current ratio is current assets divided by current liabilities. If the figure is more than 1, it shows that the company can meet its 1 year’s requirements without much problems.

The Return on Equity (ROE) is at 11.42% with reserved valuation. Without it, it’s 21.6%. ROE is calculated by dividing net earnings over shareholder’s equity. It shows how much the company is generating using the shareholder’s money. TMC’s ROE is low at 11.42% because every year, it re-valuates the freehold land the building is sitting on. Usually, for ROE calculation, the purchase price of the land is used instead of re-valuating it every year. I believe that the value of the land has been going up very significantly compared to its net profits. So, a not-so-big number divided by a huge number brings the percentage down. Without reserved valuation, the ROE is extremely high at 21.6%. Very few companies achieve high ROE. This means that TMC is doing a good job in investing the shareholder’s money for company growth.

Return on Assets (ROA) shows how much the company is generating using its assets. It’s obtained by net earnings divided by total assets. TMC’s ROA is at 9.61%. This is good.

Cash Return On Invested Capital (CROIC) tells us how much cash our company can generates on every dollar it has invested into its operations. When a company generates cash, it has two choices—pay it out to shareholders or reinvest into the company for growth. CROIC tells us if our company is doing a good job reinvesting cash for growth, or if management is hording cash when it should be letting shareholders reinvest it elsewhere. CROIC for TMC is at 13.72% and shows that TMC is doing a good job reinvesting our money.

Equity and Retained Earnings

Shareholder’s equity and retained earnings has been increasing consistently and this is very pleasing. Equity, as discussed, is how much of the shareholder’s money is in the company. Retained earnings is how much of profits is retained by the company to be reinvested so far after paying off the dividends. The equity growth rate is at 9.57%.

Cashflow

Cashflow statement is very important when analyzing a company. Cashflow statement show how much a company is actually generating in terms of real cash. Cashflow statment is divided into three segments: Cashflow from operations, cashflow from investing and cashflow from financing. We will concentrate on cashflow from operations. Cashflow from operations has been increasing consistently and this is encouraging. Capex is the amount of money going into maintaining the buildings, furnishings and equipments. Capex should be as low as possible. Average free cashflow is how much cash there is after deducting the average capex. Free cashflow is used to generate profits for the company and the shareholders. This figure will be used to project the earnings over 10 years and to calculate the intrinsic value.

Others

I found something very interesting. The number of babies delivered in TMC in FY2009 was 8,907. The number of total live births in Singapore in 2008 was 39,826 (obtained from Singapore Statistics website). This shows that TMC’s share is around 20% and that’s significant. The number of births in FY2009 is also the record number of births in TMC and it is breaking its own record year after year for 2 years already.

In summary, we want revenue, net profit, equity and free cashflow to be increasing consistently. The company should have low debts and lots of cash. The ROE, ROA and CROIC should be above the required percentages. It should also have very little Capex.

Qualitative Analysis

Now, we will look at the qualitative part of a company analysis. This is just a brief one.

Will product become obsolete twenty years from now? No. Child birth will still need hospitals.

Insider buying and/or Share buybacks (% of ownership): Executive chairman, Dr Cheng Wei Chen 36.19% ownership. Dr Cheng Li Chang, Dep Executive Chairman. Significant ownership by directors. The management decisions will be in-line with shareholders’ interests.

Strong Future Growth / Future plans: About 20% market share on live births. Opening up a hospital in Vietnam.

Management transparent and honest: Yes. Won Most Transparent Award 2008. CEO interviewed for the award. Stated in IPO prospectus that will look into overseas venture and did just that with Vietnam venture.

What I like about this business? Has hospital tours. Transparent management. Good management – 2009 ROE increased compared to 2008. Dividends increasing every yr (16% yoy GR). Deliver what they promise –Vietnam hospital. Innovative –Thomson Baby site, sponsoring events, TV shows, Thomson Women’s Cancer Clinic, VIP rooms.

What I don’t like about this business? Small hospital. But can extend to other places and with so much cash in hand and good management.

Thus, it can be seen that TMC is very profitable and has lots of growth possibilities, especially with the opening of the Vietnam hospital in the near future. Qualitatively, the important things I look for are having a management with solid integrity and future growth possibilities of company. A good management means having competent and honest management which runs the company in the interest of the shareholders and not only for personal gains. If the horse is good but the jockey is lousy, then the horse ain’t going to win. A honest management ensures that the financial statements are not peppered to make it look good.

This is how I analyse a company. It can be seen as a lot of work but as you get the hang of it, it becomes easier and it become fun as well. It’s like doing detective work, investigating if a company has been doing well for the past years and if it has not, finding out why is that so.

Are stocks risky?

A lot of people think that investing is risky. So, they would rather put their hard earned money in the bank and not lose sleep by investing in the stock market. Warren Buffett has this to say about risk: “Risk comes from not knowing what you’re doing.” So, if you don’t know anything about the stock market and you are fearful about it, then of course investing is risky! But if you read books, go for courses and talk to people who have invested, then investing would become less risky.

Personally, I’m a very risk averse person. Thus, value investing suited me as value investors analyse a business thoroughly, make sure it can deliver in the long run and demand a margin of safety before investing in the company.

So, before you start investing, always know what you are getting into. Read up on stocks, how the stock market works, who are the players in the market, how do listed companies work, etc. Then, learn how to start investing proper by reading books or you can simply google it. I have learnt about investing mostly from books. A book that I would recommend for all beginners who want to start learning about investing will be “The Neatest Little Guide to Stock Market Investing” by Jason Kelly. Try out virtual portfolio under Reuters Finance. It has free portfolio service where you can manage your own stocks using virtual money. You can access the US market, SG market and HK market with Reuters Finance. Once you learn more and your knowledge increases, you can invest with lesser risk.

Even crossing the roads can be risky if you don’t look left and right and just cross when the red man is still being shown. But you can minimize the risk by waiting for the green man (that should be the way as I’m not encouraging jay-walking). It’s the same principle when investing in the stock market…

The power of compounding

Albert Einstein once said, “Compound interest is the eighth wonder of the world”.

Compound interest arises when your current sum of money earns a specific interest in the first year and the total amount obtained at the end of the year is allowed to compound for a specific period without removing the entire sum. The earlier you start, the more the money works for you and gets compounded.

If you invest $3600 every year for 25 years at 12% per annum return (this return can be achieved by investing in the stock market and choosing your stocks wisely), you get $480,001 at the end of the 25th year. But if you procrastinate just 1 year, the same $3600 invested every year for 12%p.a. return, gives you only $425,359 at the end of the 24th year. You can see that by delaying a year, we have lost $54,642 in future value. Thus, it has been advocated by a lot of people who-have-been-there-done-that to start saving and investing early starting from your first paycheck. Strive to set aside at least 10% or more of your monthly income for savings and investments and see your money grow. Becoming financially secure and free is not that hard after all, if you know what to do.

Investing is the best way to make your money compound. Investing is essential as by putting money in the bank, a paltry interest rate of around 0.1% per annum (p.a.) is given but the average inflation rate in Singapore is around 2.7% p.a. So, by depositing money in the bank, we are actually losing 2.6% p.a. Therefore, we should all learn to invest in a instrument that beats inflation.

Another advantage of investing is that it gives you passive income. Income is divided into two categories: Active and passive. Active income is income you get from your daily 8-to-5 job. By working, you are trading your time for money and there is only so much a person can work each day. Passive income is income you get while not working. Example, from dividends, rental income, royalties and businesses, among others. Thus, one needs to have multiple streams of income. During the financial crisis in 2007, top executives lost their jobs as they were getting expensive to be paid. People who worked for 40 years in the company and some who were directors were retrenched and were helpless. Relying on your salary is the worst thing you can do to yourself and your loved ones as job security is non-existent nowadays.