“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”– Warren Buffett 1992 Berkshire Hathaway Shareholder Letter
“"Price is what you pay. Value is what you get."Benjamin Graham
I wrote about my 3 portfolios based on the principles of fundamental value investing, in particular the Greenblatt Magic Formula as published in i3investor for the last two years in this article of “A New Year Reflection of Returns of My portfolios”.
http://klse.i3investor.com/blogs/kcchongnz/67547.jsp
As many of stocks have risen in prices substantially, some of them have their business deteriorated, We will examine them one by one using the principles of the Magic Formula to see which should remain in my portfolio this year.
The Magic Formula
We will start with My First Portfolio as shown in Table 1 in the Appendix. Here is a revision on the principles of the Greenblatt Magic Formula which you have learned.
http://klse.i3investor.com/blogs/kcchongnz/51631.jsp
Earnings Yield = EBIT / Enterprise Value
Return on Capital = EBIT / (Fixed Assets + Net Working Capital)
- Enterprise value = Market capitalization + total debts + MI – excess cash
- Fixed assets generally is the property, plant and equipment
- Net working capital = Receivables + Inventories – Payable
- Ebit is earnings before interest and tax, or operating profit
- MI is minority interest if any
The Magic Formula for Pintaras and Kimlun
I am taking these two construction companies as examples for the discussion as both of them appeared in My First Portfolio. I compute the two components of the Magic Formula with their closing share price of RM3.73 and RM1.19 respectively at the end of the year 2014.
There are a few adjustments I have made. First for the formula I use after-tax Ebit, or NOPAT for ROIC, such that I can compare with the cost of capital, also worked out on after-tax basis. For the financial statements of Pintaras, I have isolated the incomes from its managed funds and interest from cash in banks from its “Other operating Incomes” as cash and cash equivalent has different risk and return profile as that of its foundation business and metal can fabrications. Likewise, this cash and cash equivalent has been excluded from its invested capital.
Table 2 in the Appendix shows the computations of EY and ROIC from the latest financial statements of Pintaras and Kimlun. It is shown that despite Pintaras’s share price has risen by 151% since two years ago, its earnings has also increased resulting its EY still high at 14.7%, substantially above my requirement of 10%. Its ROIC remains high at 29.7%, one which you won’t be able to find in any construction company in Bursa. Its ROIC has been increasing steadily from 17.4% since 6 years ago. Pintaras has been paying more than 40% of its earnings for the last few years as dividends, it has shown that it “over an extended period can employ large amounts of incremental capital at very high rates of return” for the past.
Pintaras appear to be the kind of stocks what Buffett said should hold forever. What about Kimlun?
Table 2 in the appendix shows that based on the latest financial statement of Kimlun, its EY at 11.2%, passes my minimum requirement of 10%, but just. However, its ROIC fails as at 9.2%, it is below my minimum of 10%. Something is seriously wrong with Kimlun as its ROIC has been falling unabated from 30%+ five years ago to less than 10% now. This shows that whatever money retained has been earning lower and lower marginal return year after year which is below its costs of capital.
I disliked Kimlun more of its deteriorating margins, increasing debts and most of all, and extremely poor cash flows. It never has any free cash flow for the last three years. Its cash flows from operations were even negative for the last three years. However, this seems to be improving in the recent quarters, but I have long discarded this stock from My First Portfolio
The Updated Magic Formula for Other Stocks in My First Portfolio
Again I refer you to Table 1 in the Appendix which shows the metrics of the Magic Formula and their total stock returns so far. Please note that you won’t get the exact numbers as mine as I have done a lot of approximations, some may be basing on outdated data. However, I do not think it changes my decision that much.
One can see that Plenitude appears to be the most undervalued stock with an EY of 39.4% and a ROIC of 13.1%. Actually the earnings of Plenitude is erratic due to sales of land and the last year high earnings may not be representative. However, I continue to keep this share is more of because of its grossly undervalued assets of high quality using the Graham Net Current Asset Valuation:
http://klse.i3investor.com/blogs/kcchongnz/59102.jsp
Yes I know. Its share price has dropped substantially since I wrote about it last time. That happened to me not only the first time. My excuse is stock price often doesn’t reflect its value in the short term and we will just stop there. The other is Kumpulan Fima, up by only 3.5% compared with the index of 12.9% during the same period the last two years. With a high EY of 23.3, I won’t abandon Kfima as its ROIC of 13.2% is also way above its cost of capital, and it is able to deploy its capital efficiently.
You can see that ECS ICT is a good company with great price at RM1.18 with ROIC and EY at 21.4% and 27.4% respectively. I will definite keep this stock in the portfolio. I don’t know why, may be investors think that its margin is very low. But to me that is typical of trading business. it is ROIC which is important as shown in the opening quote.
Prestariang used to be one of my top favourite stocks with very high ROIC of more than 100%. This is because of its typical light asset kind of business. However, its share price has risen substantially by 164.5% since two years ago, rendering it expensive with EY at just 4.2%. Its latest few quarters results were not impressive at all too. This is what I always say that a good company is not necessary a good investment. Hence I have long discarded this stock from my portfolio. Similarly for SKP Resources which has risen by more than 100% resulting an EY of less than 10%. It is the same for NTPM as its ROIC and EY both at the borderline. I will still keep some Pantech shares as it has good EY of 15.1% at the present price of 77 sen, down from its peak of RM1.00+. Jobstreet has sold off its core business and it no longer fit the Magic formula and hence no longer in my portfolio.
Conclusion
So that is my thought process; when the stock still exhibit the principle of the Magic Formula, I keep and hopefully let the profit run. When the business has deteriorated with ROIC<10%, or its share price has risen up above its intrinsic value and hence has become too expensive with EY<10%, I sell and take profit, especially when their share prices have risen substantially. I have sold off half of those ten stocks in My First Portfolio, and looked for other opportunities, like what I found in My Second Portfolio, which we will discuss later.
For those who are interested to learn how to search for good companies to invest with reasonable price, please contact me at
ckc13invest@gmail.com
K C Chong ( 4th January 2015)
Disclaimer: This article is for sharing of knowledge. It is not a recommendation to buy or to sell a share.
Table 1: Stock returns and the Magic Formula
| Stock |
Year-end Price
|
Stock Return
|
ROIC, %
|
EY %
|
| Kfima |
1.93
|
3.5%
|
13.2
|
23.3
|
| Pintaras |
3.73
|
151.0%
|
29.7
|
14.7
|
| ECS |
1.18
|
23.6%
|
21.4
|
27.4
|
| Plenitude |
2.29
|
30.3%
|
13.1
|
39.4
|
| Jobstreet |
0.470
|
171.4%
|
-
|
-
|
| Pantech |
0.770
|
15.4%
|
11.1
|
15.1
|
| SKPRes |
0.640
|
102.9%
|
21.3
|
8.1
|
| NTPM |
0.620
|
46.8%
|
12.6
|
9.4
|
| Kimlun |
1.19
|
38.7%
|
9.2
|
11.2
|
| Prestariang |
1.44
|
164.5%
|
120
|
4.2
|
| Average |
74.8%
| |||
| KLSE |
12.9%
|
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