Sunday, June 12, 2011

Period of Contemplation

The title of this post was actually meant to reflect my thoughts on the time required to mull over and consider a potential investment. It is also meant to be a “break” from the heavy analyses going on in prior posts on MTQ and SIA Engineering. There is another analysis coming up and planned for Boustead’s FY 2011 results. This post is to summarize some of the thoughts I have gone through while taking bus/MRT recently, and follows closely on my previous post on “Pace of Research”. I guess you can say that I would recommend reading both posts back to back, as this post is sort of a “follow-up” to the previous one.

So what exactly does the title mean? While pace of research was meant to assess how dedicated one should be while researching a company, to the extent of whether he can allocate sufficient time to dig deep into a company’s financials, stakeholders and business model; period of contemplation addresses the issue of how long one should study a company before deciding if sufficient research and study had been taken. This would naturally translate into a reasoned decision to purchase shares in the Company. The problem is that different companies have different characteristics, and I admit that some do require a lot more monitoring and following up than others, purely due to not just the nature of the business but also the way the company is run. Add to that strategic management decisions, varied management styles and an evolving business model and you get some very subjective views on how long one should evaluate a company before committing. I will now attempt to state, broadly, how much time one should adequately devote before making an informed decision.

Note that the default conditions for investment will be required, such as good margins, good and consistent free cash flow, steady earnings and decent ROE. What differs is the nature of the business and the type of industry the Company is in, as I shall elaborate.

Cyclical Companies

For companies in cyclical industries, one has to at least observe one entire economic cycle relating to that industry before deciding when, or whether, to buy some shares. Examples would be companies in construction or property like Tat Hong or Capitaland, where the housing boom/bust cycle would determine if valuations are demanding or not. Therefore, the period one should take should stretch into years if one wishes to fully understand the business cycle and determine when to make a purchase. Of course, history can always serve as a guide but the future may not always repeat itself in the same way. I would think these companies are best avoided unless you can time the cycle very well and go in at the point of lowest valuation, and just before the economic uptick.

Cash-Rich Companies in declining industries

Companies such as GRP would qualify, as they are very cash-heavy but are mired in a business which is declining and competitive. One should observe such companies to the extent that they actually plan to do something with the cash hoard, or if they undertake actions (e.g. M&A) to improve the business model. Alternatively, the investor could also study the company as a yield play, with potential to generate good FCF even in a declining industry. The time period in this case could be anything from a few months (for research) to perhaps one or two years to observe and study Management’s decisions.

Companies in new industries with low barriers to entry (many new entrants)

These are companies which have had a first-mover advantage with respect to a new and emerging industry; and therefore are enjoying supernormal profits, margins and very good cash flow. Some examples may include palm oil, bio-fuels and solar panels which are at the cutting edge of technology. However, more time needs to be spent observing such companies as many new entrants, seeing the huge profits being made by the incumbent, may scramble to grab a piece of the pie as well. The ever-changing economics and dynamics within the industry would require a longer-term study before any commitment is made. In addition, there is also not much history to fall back on as these industries may be relatively new.

Fast Growth Companies

Fast growth companies are those which are aggressively expanding, conquering new territories, opening new offices in new countries, and generally engaging in active M&A or corporate actions. They usually do not pay a dividend as profits are reinvested to grow the business. For such companies, one should observe only as long as one should in order to gain comfort on their plans, and current growth strategy. Once an understanding is formed, a position could be taken up without waiting for too long. Of course, one should also watch out for valuations – growth companies usually trade at higher valuations as a lot of potential future growth is already factored in. Investors may wish to discount for this growth in order to maintain some margin of safety.

Stalwarts and Stable Conglomerates

The final category of companies which I would like to comment on are the stalwarts, or stable blue-chips, as well as conglomerates. These would include ST Engineering and SingTel for the former and Keppel Corporation for the latter. SIA Engineering would also probably fall into this category. This type of companies probably require the least amount of monitoring and observation, as they already have an entrenched market position, steady earnings and decent cash flows. One would simply need to understand the business and be comfortable with the financials and numbers before deciding to invest, and this should not take a whole lot of time.

To summarize, the length of time taken should not be inordinately long, otherwise one may miss out of very good opportunities to accumulate shares in well-run companies, as well as miss out on the compounding effects of their investments growing over the years. Yet, one should not be unduly hasty in committing to a purchase before one has done sufficient research, otherwise the consequences could be disastrous and detrimental to one’s wealth.

8 comments:

Temperament said...

Hi,
For people like us who do not have the "skill" or "inclinations" to dig very deep into a company's books, i think we are better off buying the "established blue chips or even 2nd liners" with a history of paying yearly reasonable dividends for many years already.
Investors like us don't have to be an analyst or specialist to survive in the stock markets.
Cheers!

Createwealth8888 said...

We, retail investors are like one of the Eight immortals crossing the sea, each obviously its energy.

Eight immortals crossing the sea, each obviously its energy

Some use lots of energy and some use little energy to cross river. But, make sure you cross river and don't get drown.

Look for a "mentor" and seek out your "magical weapon" to help to cross the river.

Ken Tan said...

Hi MW

Very good article!

Like the part that you mentioned on the time invested (i.e. as an estimation point) to study various types of companies. And this should be align with one's investment objective, time horizon, risk appetite etc.

For me, I will like to have a mix -the shortest time frame to analyze will be the cyclical companies as business cycles evolve quickly and usually are based on hypothesis or generalized forecasts, using historic data intelligence - some of which are readily available in broker reports and the internet.

Musicwhiz said...

Hi Temperament,

Yep I agree with you on this, but then again there must be some way of determining what is considered "fair value" for purchasing these blue chips. I reckon that the STI offers a simple yet effective "barometer" of sentiment and valuation, so if you want to purchase based on the index levels alone you would do well to study history to determine entry and exit points.

That said, after 6 years+ I still don't find it easy to "survive" in the stock market haha. It's not been easy and yet I am still learning daily.

Regards,
Musicwhiz

Musicwhiz said...

Hi CW8888,

Haha good analogy!

But too bad for me I don't have a mentor, in fact I never did! I've learnt about investing through the tireless sharings of some esteemed value investors on the old Wallstraits Forums, as well as reading up intensely on the subject (plus applying my own modifications to the selection process).

As I've told Temperament, it's still an ongoing learning process and I don't find the going easy.

Cheers,
Musicwhiz

Musicwhiz said...

Hi Ken,

Thanks, though I did not feel that this was one of my better articles. Somehow I felt I could have written it better, or expressed certain ideas more clearly and succinctly.

While I agree with you on cyclical analysis, I would also like to drum home a very important point - always pay attention to the numbers of a Company! Without those, one cannot make a truly informed decision.

Thanks!

Musicwhiz

Temperament said...

Hi MusicWhiz,
You are 101% right. In the stock markets nobody can say he has already a "PHD" or even a "Degree". Even the great WB had admitted some mistakes in the 2008/2009 melt down "fire sale shoppings". Ha! Ha!
So who are we, dare to say we know it all already. But what i like to say is everyone has his own way of surviving and hopefully prosper in the markets.
From my experience, he who has done his homework, must also has patience, long time horizon and most of all luck or blessings(depend on what you believe.) Of course i am talking about "Value Investing"
Shalom.

Musicwhiz said...

Hi Temperament,

Thanks for your advice! Yes, I really do hope that I have paid my dues and that I can "make it" in investing. I guess only time will tell.

Shalom too!

Regards,
Musicwhiz