Saturday, September 10, 2016

ColdEye's Investing

I m keeping this value piece of value-investing, shared by KCChong ... on ColdEye's investing principle. Yes ... I will take an effort to meet ColdEye ... and KCChong, one day. They are great guru in fundamental analysis.

TTK : I was from fundamentalist school ... and moving back there as I m preparing for market-crash. As you do not know me ... you thought I m a pure chartist. I am not and agreed to you that only fundamentalists would profit hugely from stock-markets in long run. So ... lets share and learn.

written by KCChong.

The Five Principles of ColdEye
In one of his presentations given to the public on 16th March 2013, Mr Fong listed his 5 principles in investing. Rather he emphasized that investors should look out for this 5 things before he invest in that stock:

1. Return on equity, ROE,
2. Cash flows
3. PE ratio
4. Dividend yield and
            5. Net tangible asset backing per share, NTA

  1. Return on Equity (ROE)
If you invest RM100000 in a business, you would want to have a reasonable return from your capital, or equity you put in. A business is risky and probably you may want a minimum return of say 25%. For investing in the share market, you may want a minimum return say 10%, 6% above the return you get from bank deposit. If the business only returns you 4%, why would you want to invest in it when you can get that rate from bank fixed deposit without having any worry at all?

ROE is one of the most important profitability metrics. ROE reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson on the balance sheet, you will remember that shareholder equity is equal to total assets minus total liabilities.

Mr Fong mentioned that companies customary retains a portion of their earnings and the equity base grows with it. The test of efficiency of the managers in managing the business is whether they can return a high ROE from the money retained in the business, not if the earnings grow or not. He mentioned that this metric has become his most important yardstick in determining if a stock is good to invest in and he will not invest in a company with low ROE.

2.Cash Flows

Mr Fong mentioned that cash flow is the next important metric in his investment. In your business, you would expect that all your debtors pay you promptly and that you don’t have to stock up a lot of inventories which will tied up your capital. Otherwise you would have to put in more capital, or borrow more money each year even though you appear to make money. I would expect the hard cash I can received must be about the earnings I make each year or even more as the expense item on depreciation in the income statement is not a cash outflow and hence are added back to net profit to get cash flows from operations.

My business would also require capital expenses each year to keep it going, better growing bigger so that I would earn more in the future. This I would need to buy more and replenish the equipment, buy or open more shops etc. It would be ideal if these expenses can be met with the cash I receive each year and not having to come up with more of my own money or borrow from bank. After that, I would be happy if there is still money left for me to draw out (as dividend), or the company can have extra money to invest in other lucrative business. This money available after all the Capital expenses is termed as free cash flow, or FCF. It is this FCF from which dividends are paid out by companies.

As FCF is hard cash left after all expenses including capital expenses, I would be happy if the FCF is more than 5% of the revenue I am doing. FCF of more than 10% would be fantastic.

3.  PE Ratio

A good business as shown by high ROE and good cash flows may not be a good investment. It all depends on if the price is right. If the above business make a lot of money, say 30000 a year, or 30% (30000/100000), would you buy it if the asking price is 1 million, or a PE of 33 (1000000/300000)? This will give you an earnings yield (1/PE ratio) of only 3%. This yield is lower than bank fixed deposit, and why would I want to invest in a risky business with that meagre return, unless it has huge earnings growth in the future? Hence a good business does not mean it is a good investment if the price, as measured by PE ratio, is too high.

As an investor, I am willing to pay a price of no more than 15 times earnings for a normal growth company, and may be up to a PE ratio of maximum 20 for a light asset and high growth company.

4.  Dividend Yield

“A stock dividend is something tangible-it is not earnings projection; it is something solid, in hand. A stock dividend is a true return on the investment. Everything else is hope and speculation.”
Richard Russell

How nice it would be if the business earns enough for me to draw down 10,000 a year consistently. For my dividend yield would be 10% (10000/100000), or 2.5 times that of FD rate of 4%. Besides, my business may still be growing and would provide me with higher dividends in the future. Hence many investors looking for regular income emphasize on dividend yield. In actual fact, dividends are the “real” return provided to investors as they are given out as cash, in oppose to the illusive earnings, or net profit. A dividend yield comparable to fixed deposit rate will be good.

5.  Net tangible asset

“A healthy Balance Sheet is akin to a healthy lifestyle, it gives the best chance of avoiding a damaging illness, namely a financial crisis.”

Well if at the end if I want to exit from the business, if the net tangible asset of my assets worth more than what I put in, or more, I can recoup my initial investment. These assets must of course the more valuable the better, for example hard cash, property and land etc., rather than some money which I have been arguing with the debtors whether they are going to pay me or not, or some inventories which are outdated, or a worthless “Goodwill”.

Take care of the downside, and let the upside takes care of itself

Hence NTA is important too and I generally won’t pay a price more than one and a half times its NTA. In some businesses, example the service industry, technology companies and other light assets industries, there are valuable intangible assets such as their people, technology or brand names which are not reflected in the NTA.

The 5 yardsticks of ColdEye investing strategy is a very intuitive and powerful strategy.

It invests in good companies, companies with high ROE and good cash flows when they are selling cheap at low PE ratio, low Price-to-NTA, and high dividend yield.

Time to watch Liverpool's game.


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