Tuesday, October 02, 2007

Paying Too Much for the Future

Weird title eh ? Well, actually this title signifies a person who chooses to put in too much of his money into a company when valuations are rich, thus ending up "paying too much". The problem, of course, is in ascertaining how much you should actually pay and how to avoid over-paying.

Let's start off with the basics: say I offer you a cheeseburger. How much will you be willing to pay for it ? $2 ? $3 ? Maybe even $6 if it was from Carl's Jr ? But would you, in your right mind, pay $20 for a single burger ? Not unless it's justified, you might tell yourself. The same thing happens in the stock market on a daily basis. A company is offering $0.10 per dollar of earnings but people somehow pay $0.20 or even more, not realizing that they over-paid. But wait, you again say, perhaps these people are paying for what the company will be worth in future ! Good point, but then how will we know what the value of the company will be in say, 2 to 3 years time ?

This is where value investing and using valuation methods come in. If we want to pay for future growth, we have to be sure we are paying a good price for it. Even for a good company like DBS, SIA or Cosco, one should NOT pay too much for a certain rate of growth; otherwise you will find that it will take years for the company's earnings to catch up with the price you paid. This is also one of the reasons why people start lamenting that they are not making money even though the company is fundamentally strong; this is because they paid too much for it in the first place !

In today's bull market, where the STI has breached the 3,800 mark, this warning will ring very loudly and serve as an alarm bell for people who may think of purchasing part-ownership of a company. Please do note that many analysts are using FY 2008 valuations to justify their target prices (some even use FY 2009 so they can come up with a more inflated number), and the prices they come up with can be based on very optimistic, idealistic conditions. Thus, as an investor, we should be wary of such assumptions and challenge them assiduously so that we do not end up paying more than we should. Business conditions can sometimes be very rough and unpredictable, therefore investors should take note that in the most optimistic projections, there are bound to be some possible misses in terms of revenue targets, profit targets and margin growth. This is part of the normal business cycle which all investors should think about.

So to avoid over-paying, we have to assess if the sustainability of earnings can be continued through into the future. This depends largely on how a company recognizes revenues. Be acutely aware that property companies tend to use % of completion method, oil and has chartering companies recognize revenue on a time charter basis while retail companies like Hour Glass and Sincere recognize revenue on an immediate basis (at the point of sale). One has to do a simple forecast (using a conservative net margin) to see how earnings will turn out in future periods. This will give a fair value for the company. Add in synergies in terms of JV, tie-ups and other beneficial arrangements and you obtain a rough intrinsic value. Make sure you purchase with a reasonable discount to intrinsic value in order to maintain a margin of safety. This ensures you do not "overpay" for the transaction, using a forward-earnings projection.

All I can say is, in today's market, there is hardly any margin of safety for any company on SGX. Therefore, I will sit, wait and build up my cash hoard in anticipation of the next major crash or correction. Patience will always reward the value investor; most people cannot resist the temptation to constantly buy and sell.

22 comments:

Anonymous said...

good writeup, except for the part about lack of MoS for almost all companies. A number of companies have been by the wayside for muc of the bull run (and most of the recent drop), based on NAV valuations. However, would have to consider whehter their manifest lack of liquidity is compensated enough by the undervaluation

musicwhiz said...

Hi there,

Thanks, and you are right that I made a sweeping assumption about not having MOS for almost all companies. There could very well be hidden "gems" out there but I did not undertake the research because of time constraints, and also because I do not have much budget for investing right now.

As for what you said, I think there are definitely a lot of companies trading below their NAV. But this does not mean the price offers an MOS, as the growth prospects of the companies have to be taken into account as well. As you correctly mentioned, lack of liquidity also means these companies will be trading at a substantial discount to their fair value.

Regards, keep the comments coming ! :)

musicwhiz

Anonymous said...

MW,

One must always recognize that greed is a very strong human emotion. Always take a pinch of salt is someone tells you that because of certain forward earnings, stocks justify such and such a pricing.

stock prices reflect human emotions (apart from valuations). Greed and Fear are the 2 strongest emotions for investors. Bubble can get really BIG before it implodes.

We are on different strategies. If one really want to make serious money (note I say serious not easy, it is never easy to make lots of money in the market), I would pay attention to the overall market condition.

If it asks you to get out, GET THE HELL OUT and don't look back. It is the amateur trader/investor who will join the party towards the end and stubbornly hold on to their losing stocks.

The market is a great humiliator and teacher. A fool and his money is easily parted in the market.

Have a good one and please keep blogging.

MM

Anonymous said...

hi,

i was wondering how i could calculate the free cash flow of a company. is it under the 'net operations profit'?

another thing is the total number of shares outstanding for a company. is it found under the 'earnings per share' header in an annual report?

fishman said...

Hi mw,

Yes I agree that the best strategy right now is probabbly to sit and wait!

And it suits me well because I'm short of cash due to my big ticket purchases coming up....hai

Lucky it's the bull right now, if not I'll cry! Just hope I can accumulate enough by the time the bears return!

3x cheers for value investing!

musicwhiz said...

Hi MM,

Thanks for dropping by ever so often to share your insights, it's good to hear more words of wisdom from the gurus from Wallstraits !

Yes, overall market condition is important as well. Though I do not track the intimate ups and downs of each counter, nevertheless I still keep track of the business news and overall market "feeling". This is of course in response to various economic stimuli which are a daily occurrence.

Of course, people who come to the party late always have to pay the highest price for being tardy. It's a fact of the market and cannot be avoided unless you are darn lucky lol ! The market is indeed a great teacher, I have learnt many valuable lessons from the market which I hope to share with all my readers.

I will continue blogging, thanks for the encouragement !

Cheers, musicwhiz

musicwhiz said...

Hi Anonymous,

For FCF, you must look at the cash flow statement to get a better idea of how the company utilizes cash. Frankly I have yet to seriously use this in my analysis and will begin to incorporate this in future, thanks for the reminder ! You can also try www.investopedia.com which will give a good explanation of any investing terms you may need.

The answer to your second question is "yes", it can be found there. This is the total number of shares in issue which is used to compute EPS. Diluted EPS is after taking in additional shares from conversion of options or warrants.

Cheers, musicwhiz

musicwhiz said...

Hi fishman,

Wallstraits.com is actually a community dedicated to value investing, and the forum there has many high quality posts from Dennis Ng, MM, dydx, d.o.g. and others too. Do check it out !

Good luck for the financing for your flat. Remember not to make it too long or too short, get a loan which suits you and your wife's financial commitments and salaries. If in doubt, I strongly recommend asking Mr. Dennis Ng for advice.

Now is a good time to accumulate cash till the next big crash or until a value investment comes along. Proper research is of course still warranted before any purchase of shares.

Good luck and take care !

Musicwhiz

Anonymous said...

MW,

I am just a simple man who is passionate about the complex market, not a guru ;-)

Even when I lose money when I was younger, I still loved it.

To paraphrase Ken Fisher " If you enjoy the market when you lose money, you will like it even more when you make money"

I am sure you have put in lots of hardwork to generate the returns that you get. Hard work is what others don't see when they envy your results.

You make me want to go VALUE ;-)

I am a strict growth investor who follows the CANSLIM model with some personal modification. ;-)

Have a good one and I will come back every so often to read your insightful postings.

Regards,
MM

musicwhiz said...

Thanks again MM,

I respect your views too and hope to learn more from you. CANSLIM is a model I have heard of before and I have read something on it before. I will explore more on it to see if it can be incorporated into my investment philosophy. :)

You are also very right to say I have put in a lot of hard work and research in order to generate my returns. The amount of reading and computations I do is unseen by most people who read by blog. As you say, they merely see the results and hear the updates from me and assume it is easy or simple. Making money consistently is never easy in the market, which makes me respect the market even more (when I started out I too assumed that it was easy to make money, but was proven wrong many times).

You have a great day too !

Regards, musicwhiz

Anonymous said...

hi, some time ago, i talked about sgx, being a 'casino' for traders and the likes and also their monopolistic business nature... well i've a happy problem today, the counter has just lift-off over the last few days... now the difficult one: "Should I sell as a value investor?"

musicwhiz said...

Hi Anonymous,

Well, the wway I see it, SGX is enjoying its record-breaking run due to speculation that there may be an M&A soon. In terms of earnings wise, SI states that its rolling PER is about 39 times at $15.00+, so I would say it's really rather over-valued at the moment.

As a value investor, we should sell if we see a company being grossly over-valued with respect to its earnings potential. But in this case, SGX probably can still scale up its earnings with the increase in warrants trading volume over the last couple of years. As I do not know their revenue/earnings structure in detail, I am not in s position to advise or comment.

Thus, the final decision is still up to you, the discerning investor, as you are vested (thus I assume you will have more in-depth knowledge on the workings of the company).

Good luck !

Regards, musicwhiz

fishman said...

Hi musicwhiz,

Thanks! Wallstraits.com is really a very interesting site. Better than investopedia in a way because it's more related to local context.

Once again I've benefited from your sharing!

Thanks again!

cheers,
fishman

musicwhiz said...

Hi fishman,

Glad you found Wallstraits useful. Keep up the learning ! We all learn something new daily...:)

Regards, musicwhiz

Anonymous said...

on sgx, you're quite right on the prospects.. the funning thing is all these are still guessing, i mean the over pricing stuff.. no one really know for sure if few years from today, what stock exchanges earnings would be or should be. i was having the idea that since finding a good investment idea is so rare, and only guessing on the downside, having a fairly good idea of its biz, hanging on for the long haul seems more sensible.. in any case, if we already have a sizable profit, if for a while sgx loses, say 35%, is it really such a serious matter? thanks for your reply.

musicwhiz said...

Hi there,

If you had bought SGX at a very low price (I was thinking like $5 or less), then it would probably be safe to keep it for the long term as it is also a quarterly dividend company; thus you can expect cash flows every three months.

With a sizeable increase in warrants trading and more and more people jumping onto the bandwagon in terms of share trading (a.k.a. gambling and speculating), I guess volumes can only increase in the near term. That factor, coupled with possible stakes to be made by SGX in other bourses (note I did NOT mention M&A), will probably raise its intrinsic value somewhat.

Therefore, my conclusion is: Keep this if you want the regular cash flows and to enjoy the growth of Singapore's only stock exchange. If you should need some of the cash to re-invest in another company which has better growth prospects, then it is a good time to divest.

The decision is ultimately yours, good luck !

Regards, musicwhiz

Anonymous said...

quite a good observation, however, i am not too agreeable to divest sgx for some other company before i find one. maybe is good to divulge some of the reasons to sell: 1) when a mistake is made, guess you can understand this with your gv investment now over (i am sorry to say this) 2)when sgx biz is no more growing, but asian gateway strategy is just in its infant stage 3) when funds are needed for a company with better growth, but i have no idea on any yet. maybe you can blog on "when to sell" to get a good deliberations going for value investors? i was a little perplex before i asked this question, but have since made up my mind, Quote: "things excellent is as difficult as they are rare"

musicwhiz said...

Hi there,

Ok thanks for your insights, will take note of them for future posts :)

I will do a blog post on when to say using some of Phil Fisher's wisdom as well, incorporating it with value investment principles.

Cheers, musicwhiz

Anonymous said...

Wow, there is such constructive exchange of views even in a comment column of a blog. Musicwhiz, kudos to you and your readers of course. It showed that you've built up pool of readers who are serious investor (vs traders). Keep up the good work..MW! And your readers too.

mw fan

musicwhiz said...

Hi !

Yes, am actually very glad to see a good exchange of views on a particular topic. I always like a healthy exchange of opinions so that all of us can learn more !

Sadly though, there are usually lesser comments on specific company-related events; it could be because there are fewer people vested ? :)

Regards, musicwhiz

fishman said...

Hi musicwhiz,

As a regular reader to your blog, perhaps I can share my side of the reason why there are fewer comments on specific company-related evets.

As value investors (or wannabes!), our earliest step is to define our own circle of competnece, based on our individual interest or perceived expertise. So usually I'll have more comments to make when it's a company in a field I'm interested in going into or already in. Also can share and compare notes!

So in absence of it, your well written post on general thoughts and observations on stock investing becomes easier to generate thoughts and response from me loh!

All-in-all, I think you got a great blog here with lots of readership and responses. Well done!

cheers!
fishman

musicwhiz said...

Hi fishman,

Hmmm, you are quite right on the circle of competence, I never thought of it that way. Thanks for the insight ! I guess others (like yourself) may have competencies in other industries or fields, thus they may not have much to share relating to oil and gas for example. That is understandable, though I wish some of the existing shareholders also chipped in with their views.

I guess I will do general postings now and then on investing, the stock market and behavioural finance (a new series I wish to start soon); this will invite more comments and a healthy discussion can take place.

Thanks for your compliments once again, and have a great week !

Regards, Musicwhiz