This article is written for learning, sharing and discussion purpose. It does not constitute a buy or a sell call.
Let's face it, it's hard not to be thrilled by the prospect of growth. Many investors will only invest in fast growing companies and believe that they will produce the greatest share-price appreciation. Few of them think other methods besides growth investing can produce any meaningful return. Philip Fisher of “Common Stocks Uncommon Profit” is one of the pioneers of this growth investing strategy in modern investing time.
Is growth a sure win thing in investment?
Let us look at two examples of growth companies in Bursa which I happen to know quite well to see the proposition above is true; Pintaras Jaya and London Biscuits.
Pintaras Jaya A Glowing Growth Story
Growth in revenue and earnings
Pintaras Jaya specializes in heavy foundation and basement construction works. The revenue of Pintaras grew at a compounded annual growth rate (CAGR) of 8.7% for a ten year period from RM87.4m in 2004 to RM202m in 2014. This is not a bad rate of growth but it not that great too. However, except for the year 2009 just after the US sublime crisis, its net profit grew unabated at a very high CAGR of 18.5% from RM9.9m in 2004 to RM54.2m in 2014 as shown in Figure 1 below.
Figure 1: Growth in net profit of Pintaras
Identifying a consistent profit growth company is only the first level thinking. One needs to have a second level thinking; the ability to identify what is quality growth and what is not. For this, we have to look at its cash flows, and return on capitals.
Table 1 below shows that there has always been positive cash flow from operations.
Table 1: Cash flow
|FCF per share|
The no. of shares in 2014 is not adjusted for the 1 for 1 bonus issues
On average CFFO is higher than net profit and it is growing in tandem with net profit from RM50m ten years ago to RM169m last financial year. After capital expenses, it has excess cash, or free cash flow every year, signifying the good quality of its earnings. In fact, despite its high capital expenses in recent years due to increase in job securement, it still has high free cash flow amounting to RM30m to RM40m in the last three years. It is from this free cash flow that the company is able to pay increasing dividends from 5 sen 10 years ago to 30 sen per share last year, and still has its cash and cash equivalent and equity growing impressively as shown in Figure 2 below.
The high growth in equity of more than 10% CAGR, after accounting for a dividend yield of about 5% a year is internally generated through retained earnings, without any cash call from shareholders, nor was there any borrowings. Its cash holding has also grown by leaps and bounds to RM151.7m, or RM2.48 per share based on the before-adjustment 80m shares as shown in Figure 2 below.
The Measure of quality of growth of Pintaras
The very reason that Pintaras is able to grow its earnings internally without resorting to cash calls from shareholders and borrowings from banks is due to its high return on capitals. Figure 3 below shows the return on equity (ROE) has been always above 10% in recent years, or its cost of equity.
ROE in fact has been trending up and it is close to 20% in the most recent years. As Pintaras has plenty of excess cash in its balance sheet, its return on invested capital, which is a more appropriate measure of efficiency, shows a much higher return on capital of 30%, more than 3 times its cost of capital, and double that of its ROIC 10 years ago.
Pintaras is clearly a company with quality high growth in profit which has been maximizing shareholder value. Investing in this type of high growth company from say 5 years ago would provide a much higher return for investors compared with the broad market as shown in the share price movement below.
Pintaras of course is not the only quality growth company which provided extra-ordinary return for investors. Others growth stocks in my portfolios like Scientex, Prestariang, CBIP, Jobstreet, Willowglen, SKP Resources, etc also provided superior return in relation to the broad market. They all have similar attributes as shown in another quality growth stock in the appended link below.
Other attributes of quality growth stocks are management focus on managing the companies well, rather than always appearing in the media telling the investing public how undervalued are their stocks, how they wanted to take the companies private because of the gross undervaluation etc. Most quality growth stocks also were not noticed by the investment bankers and analysts when they were small and growing. This presents good investment opportunities for savvy investors.
But are all fast growth stocks provide high price appreciation? I don’t think so. Number 1, not unless they possess some of the attributes of those quality growth stocks above. Number 2 is what the price you pay for growth is. That is the third level thinking which we will leave it to the next chapter.
London Biscuits revenue grew at about 20% CAGR for the last 10 years. This growth is one of the fastest for a Bursa company. What happen to its share price performance for the last ten years?
Its share price dropped by 69% from RM2.43 ten years ago to just 76 sen at the close before this Chinese New Year. The chart above which shows its long-term return in relation to the broad market of KLSE paints a thousand words. In the last 5 years, the total return of KLSE was about 65%, but the return of LonBis was of the same magnitude, only it was the reverse, or negative return.
If you were attracted by the high growth of LonBis and its low single digit price-to-earnings ratio and bought its shares 5 years ago and hold it until now, you would have been crying all these years.
London Biscuits’ net profit did not drop but also grow. Profit growth in the last 10 years was 83% as shown in Table 2 in the Appendix. But why did the share price dropped that badly when there was a high growth in revenue and also profit growth? The answer is found in its poor return on capital.
The return on equity
Figure 4 below shows the ROE of LonBis for last 8 years. One can see the clear trend of deteriorating ROE from 13% in 2006 to just 4% the last financial year. This latest ROE is less than the cost of equity. This is a serious shareholder value destroying. How would you as an investor feel when you require a return of say 15% investing in this company with RM100000, but only made an earnings of RM4000 a year? Don’t you think you have better use of your money somewhere else?
How else do you feel when this RM4000 the share you suppose to earn from your RM100000 capital, the management tells you that it is just an accounting number, and you have to foot in more capital to buy more and more plant and machineries for the business?
I am not kidding here. Let us look at what happens to its balance sheet and cash flow the last ten years when the company is growing at that fast pace, but with such low ROEs.
If one looks at the cash flow from operations (CFFO) for London biscuits, he may fall in love as its cash flows appears to be more than its net earnings most of the time as shown in Figure 5 below. This seems to signify the good quality of its earnings. What is the catch?
Pay attention to its free cash flows (FCF) as shown in Table 3 in the Appendix. LonBis spent tens of millions buying plant and equipment (PPE) every year without fail. There is no cash left every year after spending on PPE. The seemingly good CFFO each year was the write back from non-cash item in depreciations of PPE; high expense in PPE resulting in high depreciation.
A thorough study of its cash flow statement also shows that the management has been focussing buying and selling of PPE, buying shares of other companies such as Lay Hong and TPC at inflated prices, and sold them subsequently at a huge loss; buying Khee San at RM1.50 and still incurring heavy losses after holding for years, all in the name of growth.
Imagine, there was already persistent negative FCF in its ordinary operations, and yet throwing tons of money making acquisitions at inflated prices and incurring huge losses.
What was the results of this poor FCF? Where to find money for paying down its debts, or to give dividends? LonBis still gives dividend, although dividend has reduced from 15 sen a share 8 years ago to just 1 sen for the last 4 years. But where did the money come from as there is no FCF?
The Balance Sheet
Figure 6 again paints a thousand words. The share capital of London Biscuits has increased by 1.4 times to RM164m from RM68m since ten years ago, and its net borrowings has also increased by 164% as shown in Figure 6 below. Yes, the meagre 1 sen dividend is your own money you had to put in to subscribe to the rights issues. How do you like to put in RM1.00 per share in rights issues and get 1 sen back as dividend? I don’t know about you, if I were a shareholder of LonBis, I would be very furious.
Is Growth a Sure Thing?
The above example on LonBis obviously doesn’t seem to show that investing in growth stocks is a sure thing. But is London Biscuits an isolated case? Not all at if you refer to some of the high growth stocks as shown in the appended link below.
These low quality growth companies all demonstrate the same attributes; high growth in revenue, poor cash flow, worsening balance sheet, and poor return on capitals, and management focussing on other priorities other than the interest of shareholders. There is no coincidence at all.
In a 2002 study of more than 2,000 public companies, California State University finance professor Cyrus Ramezani analyzed the relationship between growth and shareholder value. His surprising conclusion was that the companies with the fastest revenue growth showed, over the period studied, worse share price performance than slower growing firms. In other words, the hotshot companies could not maintain their growth rates, and their stocks suffered.
However, I believe if one can find a company with the quality growth attributes of some of the stocks in my portfolios such as Pintaras, Scientex, Prestariang, CBIP, Willoglen, Jobstreet etc as described above, and buys them when their share prices are not high, I see no reasons one cannot earn extra-ordinary return in the long term.
How can you identify and differentiate a quality growth stock and a shareholder-destroying growth stock? And how do you separate the chaff from the wheat? How to acquire the fundamental investing knowledge from scratch up to second level and third level thinking to profit from investing in the stock market?
If you are interested because you wish to have a good return from the stock market, please contact me at the following email address for information for a fee-based online investment course.
K C Chong (On the 4th Day of Chinese New Year 2015)
Table 2: Financial performance of London Biscuits
|Net Income, m|
Table 3: Cash flow of London Biscuits
|Net Income 000|
|Net Capital Expenses|
|Free cash flow|