Thursday, October 31, 2013

Invested in Kumpulan Fima Part 1: Valuation

Please read the disclaimer here: Enjoy the article, bitches!

I picked up some shares in Kumpulan Fima Berhad a few weeks ago for Ringgit Malaysia (RM) 2.00 per share (approximately USD 0.63). Kumpulan Fima Berhad is a Malaysian company that generates most of its profits from its plantation, manufacturing of security and confidential documents and bulking divisions. The company may not be the next Apple or Berkshire Hathaway, but it does offer good value. Kumpulan Fima is trading at a low valuation, has a large cash balance and has a diverse range of businesses that collectively generate decent returns on capital. In other words, Kumpulan Fima is not the part-time model that has a few dozen guys clamouring to like her status updates and write bullshit comments; Kumpulan Fima is that sweet, understanding girl who you secretly want to get fresh with even though you keep telling her that she’s your “friend”. Sure you get more bragging rights if you snag the model, but you still end up happy with your “friend” because she will care and stuff.

Part 1 of this series will discuss what went through my mind when valuing Kumpulan Fima while part 2 will discuss the business performance of the company (there were just too many damn words to cram into one article). The following is the revenue and profit before tax breakdown of the company’s business divisions:      
                                                For the quarter ended
                                              Revenue (in millions)                     Profit before tax (in millions)
Plantation (mainly oil palm)         RM 24.259                                           RM 8.623
Manufacturing of security           RM 52.475                                           RM 13.222
and confidential documents
Bulking                                      RM 16.715                                           RM 9.706
Food                                         RM 18.033                                           RM 0.102
Others                                       RM 6.333                                           -RM 0.689
Total                                         RM 117.815                                        RM 30.964

The present value of a perpetuity model will be employed to help us get a better idea of Kumpulan Fima’s intrinsic value. A company can be considered as a perpetuity because an investor should, after analysing the risks, be reasonably confident that the company she invests in is a going concern and wipe out risk is minimal. To use the present value of a perpetuity model we will first need to find the company’s true earnings. I use the term true earnings to refer to the maximum amount of cash that the company can pay out to shareholders without affecting its ability to maintain current business volume.

The following are the assumptions, additions and subtractions I made to the company’s operating profits for the quarter ended June 30, 2013 to arrive at what I believe is a reasonable estimate of the company’s true earnings:
                                                                                                                                Figures in millions
Operating profit                                                                      RM 30.14
Add foreign exchange loss                                                       RM 0.741
Add share of loss in associates                                                 RM 0.689
Add depreciation property, plant & equipment (PP&E)                RM 5.662
Less purchase of PP&E                                                           RM 4.624
Less taxation (25% statutory tax rate)                                        RM 8.152
Less profit attributable to
non-controlling interests (assume 35%)                                      RM 8.56
True earnings                                                                        RM 15.90
True earnings annualized                                                       RM 63.60

Foreign exchange loss is added back to profits as sometimes you get foreign exchange gains, other times you get losses. As long as you’re comfortable with the geographical exposures and foreign exchange risk level of the company, you shouldn’t really care about foreign exchange gains and losses that arise from doing business in multiple currencies. Just like how you shouldn’t really care when some college kid or unemployed bum with well-off parents tells you that you can make big money “playing FOREX” (this shit is hot in Malaysia right now). Share of loss in associates is added back as Kumpulan Fima’s associates had been profitable for at least the past 6 years and I don’t believe that the company’s associates will continue making losses over the long-term. To be conservative, I assume that 35% of profits are attributable to non-controlling interests even though it never exceeded 31% over the past 4 quarters (the last quarter in the sample ended June 30, 2013).

Now that we’ve estimated annualized true earnings at RM 63.60 million, we will then discount a perpetual stream of RM 63.60 million back to the present using an 8% discount rate. This will give us a value of RM 795 million for the company (you can access a present value of a perpetuity calculator here). I believe that an 8% discount rate is appropriate in this case as that’s the rate that investors can reasonably expect from Malaysian equities over the long-term considering that Malaysia’s GDP has consistently expanded at a healthy pace of over 5%.

The RM 795 million we got for discounting Kumpulan Fima’s true earnings back to the present is not the company’s intrinsic value. The company has large cash holdings of RM 320 million as at June 30, 2013 and that has to count for something. Assuming that the company sets aside RM 65 million to cover its capital commitments and another RM 100 million for working capital needs (the company only has RM 124.22 million in current liabilities), there’s still about RM 100 million in excess cash that can be paid out to shareholders (after taking in to account the 35% cut of non-controlling interests). We finally arrive at RM 895 million for Kumpulan Fima’s intrinsic value by adding the RM 100 million in excess cash to the RM 795 million we got from discounting true earnings back to the present. By dividing RM 895 million by the weighted average number of common shares of 270,519,000 (including stock options), we get intrinsic value per share of RM 3.30.

It is prudent to buy stocks at a discount to intrinsic value so as to have a margin of safety in case shit hits the fan. The same way it’s prudent to have a margin of safety during sexual intercourse by getting the dude to cum outside instead of inside even if a condom is used.  I personally required a 30% discount to intrinsic value for Kumpulan Firma which meant that I could only purchase Kumpulan Fima’s stock at RM 2.31 or below. I bought the stock at RM 2.00, today the stock closed at RM 1.97.

Thank you for reading this rather long article. Hope to see you during Part 2 of the series although I can’t promise when I will finish it. I got a lot of shit to take care of and I probably have ADD as it’s difficult for me to focus on one thing at a time (it’s more likely that I’m just too fucking lazy though). Expect to see a few more articles before I finish part 2 of the Kumpulan Fima series. Take care and have a happy Halloween!

Wednesday, October 23, 2013

Bought me some shares in Citizens & Northern Corporation

Please read the disclaimer here: Enjoy the article, bitches!

I added a few stocks to my portfolio in the past few weeks but couldn’t really find the time to talk about them in this blog. I was busy researching companies, playing BioShock Infinite on the Xbox 360, and catching up on Sons of Anarchy and Criminal Minds.

I bought me some shares in Citizens & Northern Corporation (stock quote: CZNC) for USD 20 a share. Citizens & Northern Corporation is a bank with good profits and a reasonable valuation of around 11.7 times earnings. The bank achieved returns on average assets (ROA) of 1.55% while Wells Fargo’s ROA was at 1.52% for the 9 months ended September 30, 2013. However, the bank achieved returns on average equity (ROE) of 10.57% which is below Wells Fargo’s ROE of 13.25% for the 9 months ended September 30, 2013. The reason for Citizens & Northern Corporation’s lower ROE is its very high capital ratios.

Some of the factors that contributed to Citizens & Northern Corporation’s superior profitability are its relatively healthy net interest margin, low charge-off rates and cost-efficient operations. As with all my analysis of U.S. banks, Citizens & Northern Corporation’s business performance will be benchmarked against Wells Fargo’s business performance. Wells Fargo is after all the badass, boss, jefe, don, big kahuna of the banking industry. Citizens & Northern Corporation had a net interest margin of 3.97% while its net charge-off rate was at only 0.19% for the quarter ended September 30, 2013. On the other hand, Wells Fargo had a net interest margin of 3.44% while its net charge-off rate was at 0.48% for the quarter ended September 30, 2013. Citizens & Northern Corporation has kept operating costs under control. The bank’s efficiency ratio of 57.14% for the 9 months ended September 30, 2013 is in line with Wells Fargo’s efficiency ratio of 58.2%.

The bank’s management has shown impressive skill at managing credit risks and maintaining the high quality of the bank’s loan book. Citizens & Northern Corporation’s net charge-off ratio was not just lower than Wells Fargo in the most recent quarter. The bank’s net charge-off ratio was, on average, significantly lower than Wells Fargo over the past 5 years which was a difficult period for banks. For the 5-year period of 2008-2012, Wells Fargo's net charge-off rate was between 1.17%-2.30% while Citizens & Northern Corporation’s net charge-off rate was only between 0.04%- 0.26%. The bank’s non-performing assets to total assets ratio stood at 0.83% as at September 30, 2013.

The bank has a strong deposit base to fund its loans, securities and other investments. The bank’s average loan to deposit ratio was 0.68 for the quarter ended September 30, 2013. 71% of the bank’s average deposits are made up of cheap deposits (checking, money market, savings and demand deposits) for the quarter ended September 30, 2013. Finally, Citizens & Northern Corporation has rock solid tier 1 and tier 2 capital ratios of 24.90% and 26.17% respectively as at September 30, 2013. This gives the bank the ability to absorb a large amount of losses before facing the risk of insolvency.

Thursday, October 10, 2013

Profitability Checklist

I have a confession to make: I don’t have a fixed system when it comes to my investment research. I just keep calculating ratios, analysing risks and looking stuff up on Google until I’m reasonably sure I’ve arrived at the company’s true earnings power and its risk exposures. But I’m pretty sure that I can’t be an investing badass unless I have a proper system for analysing companies. That’s why I decided to create a checklist of the things I generally look for when researching companies so that I have some sort of framework which I can follow when I analyse stocks in the future.

When you cut through the bull shit, investing is all about maximizing risk-adjusted returns. It therefore seems proper for me to break my investment checklist into two: one covering profitability and the other covering risks. The following is my profitability checklist:

Return on equity (ROE):Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns” – Charlie Munger. Investors should listen to this O.G. of investing and look for companies that generate superior returns on capital. I generally require a company’s long-term returns on equity to be at least 12% before I would consider investing in its stock.

Return on assets (ROA): Some companies might boost their ROE by using a large amount of financial leverage. It is therefore important to compare a company’s ROA with that of its competitors to determine whether the company is actually earning superior profits without the excessive use of debt. Unlike the ROE, I don’t have any requirements on how high the ROA has to be so long as its high in relation to its competitors. This is the case as different industries have different ranges of ROA. For example: The beverage industry has significantly higher ROA than the banking industry.

After finding a company that generates superior ROE, you need to make sure that the company is able to sustain above average profits over the long-term. We need to look into the 2 main factors that determine a company’s profitability: the industry that the company is in and the company’s competitive advantage.

Industry analysis: You know you’re in a sucky industry when there’s fierce competition, powerful suppliers that bust your balls and customers that won’t think twice about telling you to go fuck yourself. But seriously, read Michael Porter’s 5 competitive forces to get a better understanding of the stuff that determine industry profitability. Once you have identified the main competitive forces that make a certain industry attractive, ask yourself if those forces are here to stay for the long-term?

Sometimes you may find a good company in a bad industry. There's absolutely nothing wrong with investing in those companies. Just like there's absolutely nothing wrong with dating the rare hot girl that does programming. Tight is tight! 

Competitive advantage: Strong brands, efficient systems, valuable patents, economies of scale, access to cheap supplies, intelligent management and high quality, difficult to replicate product offerings are some of the sources of competitive advantage and superior profits. Investors need to be able to make a reasonable determination as to the sustainability of a company’s sources of competitive advantage.  

True earnings: A company’s intrinsic value is simply the cash that shareholders can take out from the company over its life discounted at an appropriate rate. True earnings is therefore the cash that can be paid out to shareholders after deducting costs and the capital expenditure necessary to maintain current business volume. The cash don’t have to be paid out as dividends of course as shareholders will still reap the rewards if management is able to profitably reinvest in the business (see the profitable redeployment of capital section).

Some of the stuff involved in arriving at a company’s true earnings power are: adjusting for one-time items, smoothing out earnings to account for downturns and finding the capital expenditure needed to maintain current output. The topic of calculating true earnings is kinda detailed and deserves an article of its own (which I plan to write in the future). 

Revenue growth: For a company to continuously increase the cash it generates for shareholders (and therefore its 
intrinsic value), it will have to increase its revenue. There's only so much cost cutting that a company can do. I generally require a company to have grown its revenue at a compounded annual rate of at least 6% over the past 10 years. I would require the company to have a higher growth rate if its revenues are in a currency with high inflation risk.

Operating profit growth: Profits should be the only reason for you to ever do anything. Don’t let Obama tell you anything different. It’s pointless for a company to grow its revenue if it doesn’t result in a growth in operating profits as well. I usually require the company to have grown its operating profits at a compounded annual rate of at least 6% over the past 10 years (after adjusting for one-time items and smoothing out earnings, of course).

Philosophical side note: Profits don’t have to be in the form of money, as long as you’re getting something of higher value in return for your efforts you’re profiting. I personally profit every time I grab myself a McDonald’s double cheeseburger.

The purpose of looking at the company’s past revenue and profit growth is to check if management is capable of expanding sales and profits over the long-term. However, past performance does not guarantee future results. To get a rough idea of the company’s future revenue and profit growth rates, investors need to know the projected growth in industry demand as well as the market share breakdown for the industry’s major markets.

Profitable redeployment of capital: A company usually reinvests some of its profits to expand its business. However, management’s efforts to grow the company may actually be a disservice to shareholders. To find out if a company is redeploying capital at an acceptable rate, investors should look at the company’s returns on incremental equity. I usually require the company to have achieved a compounded annual return on incremental equity of at least 12% over the past 5 years (after adjusting for one-time items, smoothing out earnings, yada yada).      

The stuff on the checklist should be thought of as guidelines instead of rules set in stone. I have invested in stocks that did not meet all the criteria on the list because I felt they were cheap and that I could flip them for a tidy profit once the markets realized they were undervalued. However, this is not where the real money is at. You make the big bucks by buying top quality stocks at a reasonable price and holding on to them for the long-term. Top quality companies usually exceed most if not all the criteria on my lists.

The lists contain only general stuff that applies to most companies. Investors need to have an understanding of industry-specific stuff before they’re able to properly analyse a company. You can’t really tell if a bank is badass if you don’t know its net interest margin, average charge-off rate, efficiency ratio, tier 1 capital ratio and etc. Anyway, thank you very much for reading! I hope that you will check out my risk management checklist in the future as well.