Tuesday, 26 November 2019

Earning Power

It is properly defined as a rate of earnings which is considered as "normal," or reasonably probable, for the company or particular security.

It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past. 

Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well defined earning power.

However, the term is often loosely used to refer to the average earnings over any given period, or even to the current earnings rate.

Benjamin Graham


Invest for the long term earning power of the company to give you compounded returns over many years.

Total Assets and Total Liabilities

The totals of assets and liabilities appearing on the balance sheet supply only a rough indication of the size of the company.   Balance sheet totals may be readily inflated by excessive values set upon intangibles, and in many cases also the fixed assets are arrived at a highly exaggerated figure.

On the other hand, we find that in the majority of strong companies, the good will which constitutes one of their most important assets either does not appear upon the balance sheet at all or is given but a nominal valuation (usually $1).  There was once a practice of writing down the fixed assets, or plant account, to virtually nothing in order to save depreciation charges.  Hence it is a common occurrence to find that the true value of a company's assets is entirely  different from the balance sheet total. 

The size of a company may be measured in terms either of its assets or of its salesIn both cases, the significance of the figure is entirely relative, and must be judged against the background of the industry.  The assets of a small railroad will exceed those of a good sized department store. 

From the investment standpoint - especially that of a buyer of high-grade bonds or preferred stocks - it may be well to attach considerable importance to large size.  This would be true particularly in the case of industrial companies, for in this field the smaller enterprise is more subject to sudden adversity than is likely in a railroad or public utility. 

Where the purchase is made for speculative profit, or long-term capital gains, it is not so essential to insist upon dominant size, for there are countless examples of smaller companies prospering more than large ones.  After all, the large companies themselves presented the best speculative opportunities while they were still comparatively small.

Benjamin Graham

Balance Sheets in General

A balance sheet shows how a company stands at a given moment.  There is no such thing as a balance sheet covering the year 2018; it can only be for a single date, for example, 31st December, 2018.

A single balance sheet may give some indications as to the company's past, but this may be studied intelligently only in the income accounts and by a comparison of successive balance sheets.

A balance sheet attempts to show how much a corporation has and how much it owes.  What it has is shown on the asset side; what it owes is shown on the liability side.

The assets consist of the physical properties of the company, money it holds or has invested, and money that is owed to the company.  Sometimes, there are also intangible assets, such as good-will, which are frequently given an arbitrary value.  The sum of these items makes up the total assets of the company, shown at the bottom of the balance sheet.

On the liability side are shown not only the debts of the company, but also reserves of various kinds and the equity or ownership interest of the stockholders.  Debts incurred in the ordinary course of business appear as accounts payable.  More formal borrowings are listed as bonds or notes outstanding.  Reserves, may sometimes be equivalent to debt, but frequently they are of a different character.

The stockholders' interest is shown on the liability side as Capital and Surplus.  It is often said that these items appear as liabilities because they stand for money owed by the corporation to its stockholders.  It may be better to consider the stockholders' interest as representing merely the difference between assets and liabilities, and that it is placed on the liability side for convenience to make the two sides balance.

The total assets and the total liabilities are thus, always equal on a balance sheet, because the capital and surplus items are worked out at whatever figure is needed to make the two sides balance.

Also read:

The Reserves of a company is purely a paper entry.

Monday, 25 November 2019

Accounting, the language of business.

Whether you are a disciple of Ben Graham, a value investor, or a growth or momentum investor, you can agree that a stock;s price must relate to its financials.

From time to time investors ignore basic numbers like book value, cash flow, interest, and various ratios that fundamentally value common stock.  It is especially common during periods of exuberance or fear that investors depart from the fundamental methods of successful investing.

A sound understanding of how to read the basic financials should keep investors focused and thereby avoid costly mistakes, and also helps to uncover hidden values of the stock market.

Ben Graham's principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.

Concept of Interest Coverage is akin to Concept of Margin of Safety


Interest Coverage:  This is the number of times that interest charges are earned, found by dividing the (total) fixed charges into the earnings available for such charges (either before or after deducting income taxes).

Interest Coverage
=  Earnings (before or after income tax) / total interest charges


Margin of Safety, in general, is the same as "interest coverage."

Formerly used in a special sense, to mean the ratio of the balance after interest, to the earnings available for interest.

Margin of Safety
= Balance of earnings after interest / Earnings available for interest.

For example:

Interest  $100
Earnings  $175

Interest cover $175/$100 = 1.75x
Balance after interest = $175 - $100 = $75

The margin of safety (in this special sense) becomes
= $75 / $175
= 42.86%

Understand the Intrinsic Value

Intrinsic Value is the "real value" behind a security issues, as contrasted with its market price. 

Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.

Benjamin Graham

Saturday, 26 October 2019

iCapital.Biz Berhad price chart since listing

iCapital.biz performance over the last 14 years

iCapital.biz was listed at the end of 2005 with a NAV of around RM 1.00.

On 24th October, 2019, its NAV was RM 3.21 and its share price on 25th October, 2019 was 2.42 per share.

Over the last 14 years, it gave 1 dividend of 9 sen per share.

Over the course of the last 14 years your investment in icapital.biz grew from $1.00 to $3.30, its compound annual growth rate, or its overall return, is 8.90%.

Share price fluctuations of iCapital.biz over the last 14 years

iCapital.biz traded at a premium to its NAV in its early years of listing. It was trading at high price of RM 2.48 in the early days of January 2008.

Its price crashed with the Global Financial Crisis. The premium to its NAV disappeared and it was trading at a huge discount to its NAV when its share price crashed to 1.06 in October 2009.

Since then, its share price has climbed upwards steadily over the years and always trading at a discount to its NAV.

On 25.10.2019, icapital.biz is priced at RM 2.42 per share.

So, who are the winners or losers in this stock?

The initial shareholders who hold onto to their shares until today from listing are obvious winners.

The buyers of this stock in and around January 2008 were obvious losers. They would have bought at very high prices and at huge premium to its NAV too.

However, for those who held onto this stock even when bought in January 2008 for the long term and who continued with a dollar cost averaging strategy over the years, they might still be winners overall.  This requires discipline and a firm investing philosophy.

Those who bought into icapital.biz from October 2008 when its price was the lowest and at any time subsequently and held till today are also winners, provided they bought below 2.42 per share.

Yes, there are obvious winners in this stock but they have to be in this stock long term and have done continuous buying of the stock over time (dollar cost averaging) when the price was obviously not too high.

Are there more winners or losers in this stock?

I believe the majority of players in the stock market are short-term traders. As traders, they are in at the time when the stock enjoys some popularity and they are out when the stock appears disfavoured. 

Thus, they are likely to be in the stock at the time when the prices were high and out when the prices dropped; they bought high and sold low.

I think icapital.biz is no different from other stocks in the Bursa. Though over the long term, icapital.biz has delivered positive returns, for those who have bought and sold icapital.biz stocks over the years, on an aggregate, there were more losers than winners.

The risk in investing is not the stock.  It is the person staring back at you in the mirror:  YOURSELF.

Suggested further reading:
No One is Immune from The Party Effect or Recency Bias

Friday, 27 September 2019

Some Ideas on Managing Portfolios

Portfolio management is more than the sum of the purchase of attractive stocks.

Here is a view on the overall lines of action on managing portfolio:

  • The first step (optional) involves trying to acquire some idea about where we are in the cycle.
  • Diversification
  • Stock selection should be bottom-up.
  • Pay particular attention to the weight of stocks in the portfolio.
  • Changing weights.
  • Sectoral efforts.

1. Where are we in the cycle? (Optional)

This involves trying to acquire some idea about where we are in the cycle.

Should we be moving towards defensive stocks, or - on the contrary - starting to be more aggressive, if we judge the declines to have been sufficient?

It is helpful to analyse the message coming from the types of stocks that interest us, so as to draw the right conclusions about what is going on. If some stocks in a sector have taken a particular hammering, it is likely we will be at the bottom of the cycle in that sector.

Overall market developments will also give us some insights. If there have been lots of very strong rises, we will be heading towards the end of a cyclical expansion, while after a series of large losses, we will doubtless be close to the bottom.

However, there is no guarantee that our analysis of the cycle will be successful.

If we are able to have some degree of clarity on the overall or sectoral cycle, then the next step is to consider which types of stocks will us in this context.

We need to buy the most aggressive stocks during low points in the cycle, even if it can be challenging to overcome the mental barriers to do so in such a negative environment. And vice-versa at the top of the cycle.

Designing the appropriate strategy for the general or sector cycle can be what adds most value to a portfolio.

2 Diversification

Our portfolio should be prepared to withstand any situation, be it a market collapse or a boom, inflation or deflation, for all possibilities. It must be agile and resilient against any eventuality.

We also have to insulate the portfolio from our own errors, whether they be our view of the cycle or our choice of companies. We have to envisage how our portfolio would be affected by the opposite scenario to what we are expecting; how it would survive.

Diversification is the clearest way to prepare the portfolio for any eventuality. Having at least 10 stocks gives us a reasonable amount of diversification. If we are managing on behalf o others, it can be helpful to hold a few more, creating a portfolio of some 20 - 30 stocks. After that, there need to be strong arguments for increasing the number of stocks.

3. Stock selection should be bottom-up.

Stock selection is the first step in managing portfolios. Avoid wasting time on companies which do not stand up to greater scrutiny. It is also important to be very flexible: avoiding slipping into generic asset allocation, both for sectors and regions. If we don't understand a certain business or new technologies, it is best to avoid them.

4. Pay particular attention to the weight of stocks in the portfolio.

Over the years, we got it wrong on a number of stocks. We must be very sure of our investment if we are going to assign it a high weight in our fund, never doing so if the company is indebted.

It is extremely difficult to discern and accept investment errors: we always end up giving the benefit of the doubt to the company, since after investing so much time studying it, we find it deeply unsatisfying to sell and think that we are throwing it away. One of the ways to get around this problem is by only having small exposures to the more dubious stocks.

5. Changing weights.

One of the ways to add value in asset management is by changing the size of positions in stocks. The argument for continually adjusting is one of simple probabilities: if a stock in a portfolio rises by 10% and another falls by 10%, then there has been a relative movement of 20% which we can capitalize on. The logical thing to do, once we have studied the movements, is to lower our position in the stock that has gained value and increase it in the one that has fallen.

Some investors prefer to wait until the stock has reached the target price before offloading the entire position, or take other approaches. However, it is highly likely that our simple approach increases the potential of the fund, since it is unlikely the valuations of the particular shares have moved in the same proportion.

6. Sectoral effort.

We should focus on attractive sectors. it is impossible to be on top of every sector. As unspecialised generalists we should discriminate between sectors that are worth following - which form the focus of our efforts - while leaving the rest to one side. Not all sectors are equally attractive all the time, and it take years for the level of interest to shift.

We should devote the bulk of our resources, especially time, to the most attractive sectors. We should keep an eye on other sectors, being aware of their existence, but they should not eat up our time for the moment. By moving from less attractive to more attractive sectors we avoid wasting time, which is an extremely scarce resource in investment analysis. There will be time in the future to return to sectors left to one side.


We should steer clear of businesses that are highly indebted, since they can negate our estimates of future earnings.

Debt improves the return on capital, but the increased volatility from interest payments can become impossible to bear.

The limit for acceptable levels of debt depends on the stability of the business; the more stable - with an easy to predict outlook (toll road, electricity networks, etc.) - the more manageable the debt.

The undeniable advantage of working without debt or other liabilities is that we can withstand any situation with the necessary peace of mind.

Debt requires us to be more precise with our predictions that is desirable, especially given the near impossibility of correctly forecasting what will happen and the inevitability of devastating surprises.

Although indebtedness doesn't directly impact on the valuation, it is important to be very aware of a company's debt levels, analysing its capacity to pay back debt: size, term, restrictions, etc.

Tuesday, 24 September 2019

How bonds with negative yields work and why this growing phenomenon is so bad for the economy



About a quarter of the global bond market, or about $15 trillion worth of bonds, offer negative interest rates.

U.S. bonds are still paying something, but could go negative if there’s a recession.

Negative interest rates encourage government borrowing.

Imagine if I came to you with a deal.  Give me $10 today and I’ll return $9 to you in a decade or so.
No way right?  This is happening all around the world and on increasing basis.

Maybe you didn’t go to Harvard Business School, but perhaps you recall an early lesson from your Junior Achievement class that tells you this is not how it’s supposed to work.

You are supposed to put your money in the bank and be rewarded with interest. This is supposed to be wiser than trading your precious allowance at the candy store for an awesome, yet fleeting sugar rush.

Nicholas Colas, co-founder of DataTrek, put it plainly enough: “Bonds are supposed to pay the owner of capital something to pry the money out of their hands.”

Nevertheless, some really smart investors around the world now have invested about $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. That represents about a quarter of the global bond market.

This financial insanity is overtaking the world because bond prices are skyrocketing as stock prices are tanking. As more money flows into bonds, their yields go down — even below zero in some cases.

The good news is that U.S. Treasurys, while hovering near all-time lows, still pay at least something. The 10-year was yielding 1.62 percent on Wednesday. Still, that’s low enough to stymie financial educators as they try to convince children that they should put off instant gratification and save at least some of their allowances.

Some market observers are now warning that the U.S. could be paying negative bond rates, too, if there’s another recession. Currently, our central bank, the Federal Reserve, has set its benchmark rate at 2.25%. When the economy turns south, the Fed typically lowers rates by as much as 5 percentage points to reignite borrowing and spending.

But where else can it go after it hits zero?

Paying any government to take your money is as irresponsible as feeding children nothing but candy bars. It’s what you might call a “moral hazard,” but this term seems to have been eliminated from the economics texts following the bailouts of reckless financial institutions in the 2008 financial crisis.

Negative interest rates, and even super-low interest rates, are only going to encourage more government borrowing. This in turn allows politicians to make all kinds of grandstanding promises — until one day when the debt pile gets too big, interest rates return to historically normal levels, and taxes go up to pay for it all.

So why does this happen?

Institutional money have investing guidelines they have to follow while shepherding all their billions. Those guidelines often require them to buy bonds. The demand for these bonds is rising sharply — so they take the deal of the day.

In the end, it’s not a good sign for the economy.


Sunday, 22 September 2019

Capital Allocation by the Managers: Study their track record and their decision-making processes.

So you have bought a good company at a decent price.  You have completed the essential part of choosing your favourite stocks.

By definition, this company generates a lot of earnings and the managers have significant flexibility in terms of how they allocate this money, with a wide range off options available to them.  

It is important that the capacity to generate value through competitive advantages is also matched by an appropriate allocation of earned profit

Appropriate allocation of earned profit by the managers include:

1.  Shares buyback and cancellation of shares. #
2.  Dividends
3.  Investments in assets for growth.
4.  Acquisition of other companies to increase the company's competitive advantage.

The board should decide between these options based on the highest executed return and consequent value creation for the shareholder.

The only way you can get a fix on capital allocation is by studying the managers track record and the company's decision-making processes.  It comes down to both a quantitative and a qualitative analysis based on criteria, with experience being assigned a very high weight.

The greater the extent to which managers have shareholding interests, the more likely it is that their interest will be aligned with minority shareholders, but this step shouldn't be overlooked in any case.

# (The shareholders should ask of the management board that they give consideration to repurchasing and cancelling shares.  When you invested into the shares, you obviously believe the shares to be undervalued and this means that a cancellation would create value.  The management need not have to do it but this should be on their list.)

Companies to avoid

Avoid these companies described below.  That is not to say there are no good investments to be found, but the chances of this happening are much lower, increasing the risk of us running into a dud.

Some examples are as follows

1,  Companies with an excessive growth focus.

Growth is good and beneficial if it is the result of a job well done, which generates resources over time which are reinvested increasing the strength of the company, but this tends to be more the exception than the rule.  The obsession with high growth targets is extremely dangerous.   Once again there is an agency problem:  who are the company's management working for - themselves or the shareholders?  Growth is only a good thing if it is healthy.

2.  Companies which are constantly acquiring other companies.

If the acquisition is not focused on increasing the competitive advantage of the main business, it can end up becoming a rueful folly, or what Peter Lynch calls 'diworsification', diversifying to deteriorate.
Growth ca also ring with it two other problems:  first, more complex accounting can more easily conceal problems; and second, each acquisition eds up becoming bigger than the last, increasing the price and therefore the level of risk.

It is worth reiterating ow detrimental it can be when some mangers feel the pressure or the desire - after selling a substantial part of the company - to buy another of a similar size, instead of returning the money to the shareholders.

3.  Initial public offerings

According to a study, companies who float on the stock market via an IPO post 3% lower returns than similar companies after 5 years. 

There is a simple reason for this:  there are clear asymmetries in the information available to the seller and what we know as purchasers.  The seller has been involved with the company for years and abruptly decides to sell at a time and price of their choosing.  The transaction is so one[sided that there can only be one winner.

4.  Businesses which are still in their infancy.

Old age is an asset: the longer the company has been going, the longer it will last in the future.  A recent study shows that there is a positive correlation between the age of a company and its stock market returns.  It takes a  certain amount of time for a business to get on to a stable footing, depending on the level of demand and competition.  Until this happens, we are exposed to the high volatility inherent in any new business, with an uncertain final outcome.

5.  Businesses with opaque accounting.

Whenever there's significant potential for flexible accounting, being ale to trust in the honesty of the managers and/or owners is essential.

Long-term contractors in the construction sector, or in infrastructure or engineering projects, are examples where there is scope for flexible accounting, with latitude to delay accounting for payments or being forward income.

We can include banks and insurance companies in this category, where the margin for accounting flexibility is very significant and it is relatively simple to cover up a problem for a while, compounded by having highly leveraged balance sheets.

Prior to investing in these types of businesses, it is absolutely imperative to be certain we can trust the mangers or shareholders.  No one forces us to invest in them, so the burden of proof is on the company.

6.  Companies with key employees.

These are companies where the employees effectively control the business, but without being shareholders (the latter could even be positive).  For example,, many service companies reportedly have very high returns on capital, ut only because capital isn't necessary:  investment banks, law firms, some fund managers, consultancy companies, head-hunters, etc.

The creation of value in these businesses benefits these key employees, while the opportunities for external shareholders to earn attractive returns are limited, despite supposedly high returns on capital employed.

7.  Highly indebted companies.

"First give me back the capital, then return something on it."

Buffett also remarks that the first rule of investing is not losing money and the second and the third ..

Excess debt is one of the main reasons why investments lose value.  We do not need to flee from debt at every opportunity, when it is well used it can be very helpful, but it should not have much weight in a diversified portfolio. 

By contrast, markets don;t particularly like companies to hold cash rightly fearing that such financial well-being might lead to bad investment decisions. 

{To sleep well and to make the most of incorrect market valuation, ensure that over half of the companies in the portfolio have ample cash.  Do not be worried about excess cash, provided that capital is reliably allocated.}

8.  Sectors which are stagnant or experiencing falling sales.  

While it is not worth paying over the top for growth, on the flipside, falling sales can be very negative.  Quite often these companies can cross our radar because of the low prices at which they are trading but over the long term, time is not on our side with them..  Sometimes sales will recover but mostly the opportunity cost is to high, given that the situation can persist for sometime.

9.  Expensive stocks.

It is obvious but worth spelling out.  In reality, expensive companies have historically obtained the worst results, because good expectations are already priced in and because it is less likely that the price will jump from - say- a P.E ratio of 16 to 21 than from 9 to 14.

That is not to say that good results cannot be obtained from buying the above types of stocks, but it is an additional hurdle which some may preferred to avoid.

The above are not the only examples of companies to avoid,, but they are a good starting point.

Saturday, 21 September 2019

The Possibility of Reinvesting More Capital in companies with High Returns on Capital

Bear in mind that the potential for companies with high returns on capital to reinvest a lot of capital are limited, since they tend not be be very capital intensive (e.g. Nestle Malaysia and Dutch Lady).

Furthermore, the market will probably be correctly pricing such gems which are capable of obtaining high returns over time, meaning we must wait for the right moment to acquire them at a reasonable price, because they are rarely gong to come cheap.

If some of these companies with high returns on capital in attractive sectors also offer a certain amount of growth, facilitating reinvestment of capital, then we are looking at a gem, with the added benefit of being coherent with our long term investment philosophy.

If a company can reinvest with a 20% return on investment over the next 20 years and we are able to buy the stock at a reasonable price, then the return on our investment will be close to this annual 20% over 20 years.

How can you begin to own a portfolio of quality companies?

Settling on Quality

There is no scientific way of finding the perfect combination off price and quality.

  • Should we pay dearly for high quality?
  • And anything for moderate quality?
  • Obviously, paying little for quality would be ideal, but practically impossible.  

Uncovering real gems at an attractive price.  Over time, you will find the right balance.

A good set of businesses at an attractive price.

For example, your portfolio may have

  • an average ROCE (the companies forming the portfolio) of over 40%
  • with a free cash flow yield of over 10%  

How can you reach this point of owning a portfolio of quality companies?

You have to progressively sell off stocks that did not meet the new philosophy and to only buy those meeting the quality requirements.

It will be slow work, requiring you to sell off cheap companies (gruesome companies) and to fight against your attachment to them.

You have to be convinced that this is the right way to go and you go all in.

Searching for quality is not about blindly following formulas.

While these are a good starting point, they remove the essential human element which is of such importance to some investors.

It is not enough to find a high ROCE and low P/E ratio.

You have to understand where the profits are coming from and above all, where they are headed. This is essential and you need to spend most of your time doing this.

The possible purchase price can be readily found in the daily newspaper or in real time online, but analysing a specific sector and the company's competitive position is what enables you to determine the intrinsic value, which is neither as obvious nor as easy to identify.

This is the great enigma of investment and you have to begin deciphering it.

Share repurchases and subsequent cancellations.

Buffett has very clear ideas on share repurchases and subsequent cancellations.

Buybacks clearly make sense when

  • there are no better alternative investment options and 
  • the share is trading below the intrinsic or target business value.

The problem is that executives would rather increase company size via misplaced acquisitions,, leading to diworsification, diversifying to deteriorate, as Peter Lynch has wittily anointed it. 

Buffett believes that it only makes sense to use own shares to buy companies when you get more in return, which doesn't usually happen.

Shift to Quality

Graham was too focused on price at the expense of quality.  Of course, this is an oversimplification.   Graham also took account of other factors, such as growth or stable results, although he didn't put as much emphasis on them.  

Most investors today pay attention to other drivers, such as growth or business quality, assigning increasing weight to them over time.

Philip Fisher

Philip Fisher played a pivotal role in the transformation undergone by many investors.  It was under the influence of his partner, Charlie Munger, that Buffett first became attracted to Fisher's philosophy.

Fisher put his money on investing in long-term growth stocks, with very robust competitive advantages that were capable of being sustained and increased over time.  The price paid for them was not as important, since if the company performed well it would be able to sustain a high multiple.  

This idea is less intuitive and therefore harder to digest than simply buying something cheap; it means paying seemingly expensive prices for something that will only yield results after a period of time.

This is ultimately the road that Buffett has gone down.  Thus, most value investors are also indirectly indebted to Fisher to some degree or another.

For those who have maintained a certain unshakeable bias towards investing in cheap assets, whose quality was not always proven, it can be a challenge to change their ways, especially when this mix had produced good results.

Every investor develops at their own pace.  

Joel Greenblatt

Joel Greenblatt's short book, The Little Book That Beats the Market, gives empirical proof that quality shares bought at a good price will always outperform other stocks.  

To do so, he classifies each stock according to two criteria: 

  • quality, measured by ROCE (return on capital employed) and 
  • price, measured by the inverse P/E ratio (price to earnings, the price that we pay for each unit of earnings).  [You can also use FCF yield, that is, FCF/price, instead of inverse P/E].

Greenblatt uses a numerical classification for both return and price:  1, 2, 3,4,...., with 1 being the stock with the highest ROCE under the return criteria and 1 being the highest free cash flow under the price criteria.   He then adds the points obtained by each share in both rankings to produce a definitive classification, which he calls the 'magic formula'.  

  • The companies with the lowest sum of both factors deliver the best long-term returns.  
  • Furthermore, the same is true throughout the ranking; companies situated in the lowest 10% post a better return than the second 10%, the second decile outperforms the third, and so on until the last 10%.

The exceptional results obtained by Greenblatt is surprising, but logical:  good companies bought at reasonable prices should obtain better returns on the markets.

The problem with applying this approach is that the formulas deliver over the long term, but they can also underperform for relatively long periods, for example, three years  this makes it though for both professional and enthusiast investors to keep faith when things are not working.

The disconnect between economic and earnings growth

Saturday, 21 Sep 2019

THERE has been much debate about the lacklustre performance of Malaysia’s stock market vis-à-vis other regional or North Asian markets. There are many factors that determine a market’s performance and one of the reasons is due to the poor earnings in corporate Malaysia.
However, the other side of the argument is that, why aren’t our corporates doing well and showing earnings growth as we have been having relatively stable economic growth for years now?
Indeed, this is true. But to answer this perpetual question, one needs to understand how gross domestic product (GDP) is measured while at the other end, how are earnings derived. Is the comparison between GDP and earnings growth relevant and should they be correlated?
GDP can be measured on three counts namely by expenditure, output or factor income, and all three measurements provide the same sum of value. We typically explain GDP by expenditure and output or also known as aggregate demand and aggregate supply respectively.
Measurement of GDP by factor income is not a common practice in Malaysia. GDP measured by factor income takes into consideration income (i.e. wages and salaries); profits of businesses and the third component is rental income from ownership of land.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284546.JPG

GDP measured by expenditure or aggregate demand comprises both the public and private consumption and investment, change in value of stock and net exports. GDP measured by output or aggregate supply is measured using the output of the various economic sectors and this of course includes the services sector, the manufacturing sector, mining, agriculture and the construction sector.
In essence, GDP measures the total output generated from the economy, i.e. both the value of goods and services produced and by default, it is the measure of the size of the economy. How big is a nation’s economy in terms of the value it creates every year? When we say the economy expanded by 5%, it means the output value of both goods and services grew by 5% compared with the previous year. GDP is also measured on two counts.
One is GDP in nominal terms and the other is GDP in real terms. Of course, the difference between the two is the rate of inflation and typically GDP in real terms grows slower than GDP in nominal terms which is measured based on current values. In other words, GDP in real terms only takes into account growth of the economy while GDP in nominal terms takes into consideration not only the growth factor but the price factor as well.
GDP is also measured based on a certain base year. Today, Malaysia’s economy is measured based on the 2015 base year (from 2010 base year previously), to reflect the nation’s current economic dynamics. To get a real GDP data, the nominal GDP is adjusted by a factor called “deflator”. A deflator is a measure of inflation from the current base year of 2015. Chart 1 shows Malaysia’s GDP between 2015 and 2018. From here, we could also make a summary that deflator used for the year 2016,2017 and 2018 are 1.0166,1.0552 and 1.0627 respectively.
Earnings on the other hand, is only measured based on current prices as our accounting rules do not take into consideration inflation neither is it re-based every five years. Earnings is also a measure of profit and not revenue. Typically, for GDP, the output measure is actually revenue to the provider of goods and services and not profit. Of course, one can argue that if revenue is rising, which typically does, should it not reflect in better earnings? The straight answer, yes definitely. But, bear in mind, net profit is not cashflow and earnings are also adjusted for various accounting rules as well as non-cash items like depreciation, and amortization. So to compare GDP to earnings performance is not exactly accurate either. In addition, as defined as to what GDP actually measures, it is difficult to correlate what is spent from aggregate demand of the economy to the aggregate supply as some of this demand and supply is not captured among listed companies. Hence, there is indeed a mismatch between GDP and even revenue of our corporates.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

For example, the public sector accounts for almost 20% of aggregate demand while private sector accounts for 74% of the annual GDP. On the supply side, services sector is about 57% of the economy while manufacturing sector is at about 22%. Mining, agriculture and construction makes up the balance 20%. While some of this output of goods and services is carried out by listed companies, there is a significant amount that is not represented in the market. This include large MNCs which are not listed, SMEs, which are backbone of the economy, as well as smallholders in the agriculture sector while Malaysia’s No.1 corporate, Petronas, the parent company, too is not listed. Some of the output generated from these industries or by our national oil corporation is for exports and not all our exporters are listed either.
With this, we can now see that earnings are NOT correlated to the GDP and hence poor earnings growth over the last few years had little to do with economic growth. Based on Bank Negara’s statistics as per Table 1, we can deduce the market EPS at the end of each year by taking the KLCI index level divided by the market PER at the end of each period. The EPS growth can than be calculated from these figures and we can now see the correlation between Nominal GDP growth and EPS growth as shown in Chart 2.
The chart basically shows that since the re-basing of the GDP, Malaysia’s nominal GDP expanded steadily in 2016 and 2017 but fell back in 2018. Earnings on the other hand was negative in 2015, marginally positive in 2016 and 2017 but was extremely poor in 2018.
As the 1H reporting season has just ended, we have observed that based on data compiled by research houses, market earnings have contracted by 8.2% year-on-year and the current market estimate is that earnings for 2019 will be negative 1.8%. For this to materialise, corporate Malaysia’s 2H earnings has to be a strong 4.6% y-o-y growth to enable the annual earnings growth to hit the expected contraction rate of 1.8%. As inflation is probably to average about 1% this year, the 2019 nominal GDP growth too will likely mirror that of 2018 performance, i.e. at about 5.5% growth. Hence, while the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, well, at least for 2019.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284582.JPG

In addition, if we look at the composition of our 30-stock FBM KLCI, the index itself is heavily weighted towards the banking sector, which makes-up about 36% of the index, while Tenaga Nasional and the telco sector are the next heavyweights, accounting for about 21% of the index itself. Hence, with the banking sector not particularly performing well, especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.
The failed merger between Axiata-Digi too has now taken its toll on the index while the gaming sector (the likes of Genting and Genting Malaysia), plantation and rubber glove makers have their own issues related to governance, poor corporate results brought about by weaker commodity prices as well as stretched valuations. Hence, the poor performance of the FBM KLCI year-to-date is understandable and it is not due to the weakness or strength of the Malaysian economy but more of whether the index itself is reflective of the economy as whole or otherwise. In fact, seven companies alone represent about half the FBM KLCI weight and they are Public Bank, Tenaga Nasional, Maybank, CIMB, DiGi, Maxis and Axiata, and their market performance alone can dictate the FBM KLCI’s direction.
The views expressed here are the writer’s own.

Read more at https://www.thestar.com.my/business/business-news/2019/09/21/the-disconnect-between-economic-and-earnings-growth#9lGpHfbTTsxgsmQC.99


GDP can be measured in 3 ways:  expenditure, output or factor income.

Aggregate demand:  
Public sector accounts for 20% 
Private sector accounts for 74% of the annual GDP.

Supply side: 
Service sector: 57%
Manufacturing sector 22%
Mining, agriculture and construction 20% of the annual GDP

Output of goods and services not represented in the market:
Large MNCs which are not listed
SMEs (backbone of the economy)
Smallholders in the agriculture sector
Petronas, the parent company (Malaysia's No 1 corporate)

1H reporting season (data by research houses)
Market earnings have contracted by 8.2% year-on-year
Current market estimate is earnings for 2019 will be negative 1.8%.

Earnings is a measure of profit and not revenue.  GDP, the output measure is actually revenue to the provider of goods and services and not profit.  So to compare GDP to earnings performance is not exactly accurate either.  

Some of the aggregate supply and the aggregate demand are not captured among listed companies; hence, there is indeed a mismatch between GDP and even revenue of our corporates.

The 2019 nominal GDP growth will likely be about 5.5% growth.

While the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, at least for 2019.

30-stock FBM KLCI weightage

Banking sector 36% of the index
Tenaga Nasional and the telco sector  21% of the index

Banking sector not performing well especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.

Other issues contributing to the poor performance of the FBM KLCI:
Failed Axiata-Digi merger
Gaming sector (Genting and GENM)
Plantation & Rubber glove makers (Corporate governance issues, poor corporate results due to weaker commodity prices as well as stretched valuations).

The index is not reflective of the economy as a whole.  Seven companies alone represent about half of FBM KLCI weight and their market performance alone can dictate the FBM KLCI direction:
Public Bank
and Axiata

Friday, 20 September 2019

Impairment charge

"Impairment charge" is the term for writing off worthless goodwill.

These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs.

Impairment charges will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets.

Accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the mis-allocation of assets that occurred during the exuberant business period. In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.

Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:

1. Company made large acquisitions.
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly.

Thursday, 19 September 2019

The Quality of Companies: Practically all the value investors have gone down the same path of Buffett.

Graham was too focused on price at the expense of quality.  

However, in hindsight, it was clear that the portfolio of quality companies is the best approach to stand up to any market situations.

Indeed, past financial crises confirmed that high-quality companies at reasonable prices perform better over the long term than companies which are straight cheap.

Buffett invested in very underpriced real assets in the beginning of his investing career.   After partnering Charlie Munger, he focused on higher-quality stock, proxied by the degree of competitive advantage they enjoy.

Many investors have gone down this same path of Buffett, practically all the value investors.  The main reason is that it delivers better results over the long term, although there aren't many studies to back up this assertion, making it initially a far from obvious conclusion.

Why have practically all value investors followed Buffett, preferring quality companies?

Maybe, when they are young and start out investing, they have an excessive desire to do well and make their mark.  They tend to favour the cheapest companies, which on face value offer the greatest potential upside.

With experience and maturity, and after having stepped on a few booby and / or value traps (cheap companies in bad businesses, which languish for years, failing to create value) and their economic situation improves, their tastes tend to shift towards quality, even if they have to pay a bit more for it.

Wednesday, 18 September 2019

The company's growth plans: Your approach as an investor.

Good growth is exciting for any company that you own.

Growth can be through organic growth or through mergers and acquisitions.

However, as an investor, you should assign little importance to growth plans of the company in your investing decision.

It is far more important the company sets out the right strategy, since growth will follow in due course.

Many short-term growth targets get in the way of taking the right long-term decisions.

As an investor, you should be willing to ride out patchy results, considering this to be part and parcel of business.

On mergers and acquisitions, the investors should have a very clear stance: it is important to avoid the urge to grow for growth's sake; the focus should be on acquisitions that make sense and not overpaying.  It is important to avoid watering down a quality business with inferior acquisitions.

Business Quality

Business quality is defined by the return on capital employed, calculated before goodwill.

The implication is that better returns are synonymous with a better-quality business.

What is investing? My core.

Investing is all about buying a flow of earnings at an acceptable price.

The pace of earnings growth is a second-order issue.

Risk is the possible loss of long-term purchasing power.

Volatility of price is not risk.  It is the ally of the long-term investor.

The market is NOT ALWAYS efficient.  In general it is efficient, but NOT ALWAYS, and this small difference is crucial, enabling us to capitalise on it.

Monday, 16 September 2019

How do you select your stocks: Quality First, then Value.

A great company deserves a higher valuation. It is possible that you paid a slightly higher price than you wanted to pay for the stock, which lowers your overall rate of return, but time is on your side and your long holding time minimizes the impact of the higher purchase price to your overall return. Also, you will always find the opportunity to add to your position at lower valuations, though not necessarily at lower prices.

Deep value investing investors need to be cautious and aware of this approach's inherent problems. Those companies dropping and appearing in the deep-bargain screen probably deserved to be traded by low valuations. Their stock prices were likely low for the right reasons, and buying these would likely have resulted in steep losses.


There are many gruesome companies in the stock market. These companies operate in very competitive environments and have to be managed well to deliver good returns. In the business world, it is often the economics of the business that eventually triumph over the skills of the managers, however superb their skills maybe.

A company that performed well for 3 years and then lose its good performance subsequently is not a great company, by definition. A great company is one that can perform well, consistently and growing its earnings over 20 to 30 years.

Not uncommonly, these gruesome companies trade at below their net tangible asset prices. This is to be expected, especially if their businesses continue to be gruesome. Their low trading prices attract some investors who are enticed by the very low price relative to their net asset value.

Here is a very important point for any investor. When the price of a company falls, all its valuation ratios become very good. Its price to book value, its price to sales and its price to earnings ratios, all fall and its dividend yield (using last year's dividends) rises.

The uninitiated may think these companies are now undervalued using these financial ratios. Here lies the risk of searching for undervalued stocks in gruesome companies.

The more intelligent investors do not solely rely on these financial ratios alone, they require a lot more analysis. As a general rule, most shares are priced appropriately most of the time. It is only some of the time, when they are mis-priced too low or too high.

The risk in buying great companies is overpaying too much to own it. However, great companies do have earning power for many years, by definition. They continue to grow their intrinsic value over time. If you can acquire these companies at bargain prices (very rarely) or at fair prices (commonly), you should do well in your long term investing. Also, it is alright to pay a little bit more to own these companies as over the long time of holding them, they will still reward you handsomely. As these great companies are few, selling them only make a lot of sense if you can find another of equal quality (very difficult indeed) that offers higher reward to downside risk with high degree of probability. Well, not unexpected, this is not easy.

Buffett says: Buying a wonderful company at a fair price is better than buying a fair company at a wonderful price. He is absolutely right. Stay with quality first, then value; and your investing over the long term should be quite safe and mistakes, if any, will be few.

Friday, 6 September 2019


Pentamaster locks in RM238mil sales

Monday, 02 Sep 2019


Pentamaster executive chairman C.B. Chuah checking out test equipment produced for the automotive and semiconductor industries

GEORGE TOWN: Semiconductor automated test equipment maker Pentamaster Corp Bhd
has locked in sales of RM238mil for the third and fourth quarters of 2019, which will boost its growth by double-digit percentage over 2018.

Group chairman CB Chuah (pic) told StarBiz that
  • about 50% of the sales came from the smartphone segment
  • while the remainder were from the automotive, factory automation and medical device industries.

The average pricing of each test equipment starts from US$500,000 onwards.

“This year, the demand for smartphones has contracted. Its contribution to group revenue is expected to shrink to about 55% from 70% previously.

“The electric vehicle (EV) and factory automation solution segments are growing, ” Chuah said.

The EV segment, for example, is expected to contribute 15% this year compared to 10% a year ago. “We expect the EV segment to generate about 25% of group revenue by 2021, ” he added.

The group is now in talks with a few EV customers interested to purchase testers from Pentamaster to test the power converters used in EVs.

“These customers are from Europe, China and the United States, ” he said.

Chuah said the group would allocate more financial resources to expand its EV business segment. “We see huge potential in the EV business. During the first six months of the year, the global sales of pure EVs increased by 92% to 765,000 units, according to Jato, a leading provider of automotive market intelligence.

“This total is the volume sold in 41 markets around the world.

China’s commitment to electrification and Tesla’s sales growth were the main factors driving the growth in the first half of 2019, ” he added.

On the smartphone market, this is the worst slowdown in three years, according to Chuah.

“New smartphones are not equipped with fresh and innovative features, which is why sales have slowed.  Due to economic uncertainties, consumers are also not changing their phones.We expect to see a recovery in 2020, ” Chuah said.

According to the Connecticut-based Gartner Inc research house, worldwide sales of smartphones to end-users will total 1.5 billion units in 2019, a 2.5% decline year-on- year.

“Gartner analysts expect smartphone sales to grow again in 2020, driven by the broader availability of 5G models and the promotion of 5G service packages in various parts of the world by communications service providers. Analysts also expect the first 5G Apple iPhone to launch in 2020, which should entice iPhone users to upgrade, ” Gartner said.

Read more at https://www.thestar.com.my/business/business-news/2019/09/02/pentamaster-locks-in-rm238mil-sales#IwK0dJ6W85GtZ6kb.99