Looking at financial health of a company using debt ratios

A company can fund its operations and growth by using equity and debts. There are some debt ratios available that investors and analysts use to do a simple check into the financial health of a company. I shall provide a simple discussion on a few debt ratios with their uses and any limitations.

Debts is part and parcel of a company's capital structure. It is uncommon to find a company totally without any form of debts. However, there exists highly profitable companies (though the minorities) that do not require debts funding but all funding for the operations and growth of the company can be provided for by its retained earnings. Such excellent companies also boast of consistent high amounts of free cashflows in their accounts. As such, they employ minimal or no debts in funding their operations and growth. It is important to know where a company stands in terms of its amount of debts. A company that employs high amount of debts may run the risk of not being able to pay its debts when due and thus result in possible risk of bankruptcy.

To ascertain whether a company is financially healthy and is not employing a high debt load and burden, debt ratios are commonly used. To understand the use of such debt ratios, we need to first look at the two types of liabilities a company can incur. These two types are operational and debt liabilities. Liabilities falling under operational type include accounts payable, taxes payable and any forms of operating expenses. Liabilities falling under debts nature include notes payable, and any forms of short-term borrowings and long term borrowings.

Debt-Equity Ratio

Debt-equity ratio compares the total liabilities to shareholders' equity of a company. It reveals how much leverage a company engages. There is no hard and fast rule to tell whether a company is excessively leveraged. However, if a company is consistently more significantly leveraged to its similar competition in an industry, it may be a potential red flag for the company.

In looking at debt-equity ratio, the lower the ratio the better the financial health of a company. A lower ratio means lower total liabilities compared to the equity of a company. In using this ratio, one is considering the total liabilities which include both operational and debts liabilities. So, this ratio provides only a general look into all liabilities carried by the company compared to its equity. It does not focus on only the debts portion alone but also include other operational liabilities as well.

Capitalisation ratio

Capitalisation ratio provides a look into the amount of debts carried in a company's capital structure.

As capitalisation ratio considers only the debts portion compared to the total capital structure (capital raised by lenders and shareholders), it provides a more meaningful look into the composition of a company's capital structure. A lower capitalisation ratio indicates better financial position for a company.

Interest coverage ratio

Interest coverage ratio measures how easily a company can pay its interests on outstanding debts.

An interest coverage ratio of at least 1.5 or more is preferred. A lower interest coverage ratio may suggest that a company is taking on a high amount of interest expenses from a high amount of debts. A high interest coverage ratio also means a company has the capacity to further take on larger amount of debts (e.g. for expansion and growth opportunities) when required.

Cashflow to debt ratio

Cashflow to debt ratio provides a comparison between the operating cashflow and the total debts of a company. The total debts of a company will include short-term borrowings, current portion of long term debts and non-current portion of long term debts. This ratio seeks to measure how much the cash generated from operations can cover all total debts of a company.

Sometimes, free cashflow can also be used to substitute operating cashflow in the calculation. This will provide a more stringent measurement of the ability of the free cashflow generated by a company to cover its total debts. A high cashflow to debt ratio is preferred as it suggests the ability for the cashflows of a company to cover its total debts.

Conclusion

Debt ratios generally provide a look into the amount of debts carried by a company and measures the ability of a company to carry its debts at a financially healthy level. Almost all companies will carry different amounts of debts. Companies in different industries may also carry very different amount of debts. One should compare similar companies in an industry when using such financial ratios as the capital structure of companies in different industries may differ widely. Nevertheless, debt ratios help an investor to check for any potential warning signs on the financial health of a company. When assessing a company, amount of debts carried is only one component to look at. To have a better assessment of a company, an investor should look at the company holistically in many aspects, not just its capital structure alone.

Towards financial independence

I recently went through another audio book, "Rich Dad, Poor Dad by Robert Kiyosaki". I managed to capture some salient financial planning concepts from this audio book. After learning from various sources (e.g. audio books and seminars - see my previous posts on financial planning), I found out that all financial planning concepts point to same thing, that is the goal of reaching financial independence. As such, all concepts on financial planning tie in with one another and there is no contradiction in concepts as all concepts help the person who practise these concepts to arrive at same goal of financial independence.

In this book "Rich Dad, Poor Dad", it explained the reason why most people do not reach financial freedom. This is because of simply one thing - their total monthly passive income do not exceed their total monthly expenses. Most people may know of this cold hard truth already, but how many know of ways in which one can arrive at financial freedom. In reaching financial freedom, it is not just the methods per say that one should practise but the one and most important thing is to have the correct attitude and mindset of financial freedom. Therefore, financial freedom all begins with the correct attitude and mindset of the individual.

According to the book, one can classify his/ her finances using an accounting language. This is not foreign to many trained investors who are adept at assessing financial statements of companies. Similar to the financial statements of a company, an individual's finances can also be classified into his income, expenses, assets, liabilities and cashflows. To arrive at financial freedom, one's cashflow must always be positive. I see an equivalence of this to the importance of having consistent positive cashflows for companies as well. A company that boast of consistent positive cashflows year after year has consistent profitable business model and has use for its cashflows in reinvesting in its business, other growth opportunities or providing dividends to its shareholders.

Is active income from a job a financially stable source of income?

Now, I shall discuss more based on what I learnt from the book on the different categories namely income, expenses, assets, liabilities and cashflows with regards to an individual's finances. Most people survive on paycheck to paycheck in order to have a recurring income. Once they stop working due to any reasons, their income stops as well. This is known as active income that comes only by working. When the person stops working, he becomes financially unstable since there is no more income and he still needs money for basic survival (e.g. food, clothing).

One cannot do without minimal survival needs (e.g. without food, one goes hungry and may lead to death.). Thus, the important question to ponder is whether a person is financially stable with a job afterall? By looking at the above proposition, it may seem not. If a person ceases to be working, his income also ceases. His whole financial state starts to crumble unless he has some emergency funds to tide him and his family over a period of time while he finds another job. Anyway, a person may still due to any possible reasons in his life cease to be working (e.g. due to illnesses, disability or old age), so active income is actually not a stable form of income afterall. If one don't work, sorry - no more income for him......I am not saying that working is a bad thing here. In fact, one should continue working and contributing to people around him. One does not live as a hermit and needs to coexist with other beings and work is an avenue for rich interaction between people. So, work is important. One should work hard and contribute to people around him. However, the reality is that many people do not just work for the meaning of working. People work because they need the renumeration behind the work. They need the paycheck and need it continuously all their life. How many can actually boast that they work only for the fun and enjoyment of working to contribute to peoples' lives?

Of course, there is nothing wrong with working for a living. It is decent to work for a living. The point I am raising here is the need to reexamine how one looks at active income. Active income is not a stable form of income. It is misleading to say that one is financially secure with a job. It is in fact not financially secure at all with a job. Break off the active income source (the income paying job) and there is no more income into a person's finances.

Income producing assets as financially stable sources of income

If active income is not the way to go to become financially stable, how does one gain stable income sources? He does it by passive income sources. Passive income sources are sources of income that do not require the individual's time and effort to produce the income. Such income are generated passively (e.g. rental from real estate, dividends and capital returns from stocks and other forms of investments, royalties from books, business income from businesses not requiring one's attention). According to the book, these types of passive income come from such income producing assets (e.g. real estate, stocks and other forms of investments, businesses). So, if active income is not financially stable at all, the financially stable sources of income would come from income producing assets. To be financially stable, one should thus seek to build up his income producing assets in his management of finances. This is also the way to make money work for oneself and not the other way whereby one works for money. One can see every dollar saved and invested into building income producing assets as accumulating more workers for oneself, so as to make money become one's worker (every dollar held in such income producing assets is like individual worker, so the more money held in such assets, the more workers one have working for himself).

I guess the above illustrations are not unknown to many people. The question is why many are still not able to save and invest in such assets to build their passive income sources. We have to examine the next category of expenses and liabilities.

Expenses and liabilities stem from desires not easy to grapple with

Not all people are alike. Everyone has his own desires and many of an individual's desires can be satisfied by his expenses and liabilities. Imagine the thrill of owning one's car or a condominium. All these big ticket items are a drain to one's finances. Any items that draws away income instead of producing income are considered as liabilities to an individual. Being tied down by monthly instalments for paying car loans and housing loans make such items as car and houses as liabilities instead of assets. Some may argue that houses are assets to an individual. According to the book, as long as the item is not generating any income at all, but instead drawing out income from oneself, it should be conservatively considered as liabilities on one's finances. So, the problem with not being able to reach financial freedom is because the average person keeps tying himself down with lots of liabilities and expenses (e.g. from all loans and incessant spending) and not being able to save and invest in owning income producing assets instead.

It all begins with the attitude

In conclusion, to reach financial freedom, one needs to have the correct attitude and mindset of looking at ways to save and invest to build sources of income producing assets (e.g. rental from real estate, dividends and capital returns from stocks and other forms of investments, royalties from books, business income from businesses not requiring one's attention). Do this and reduce on one's expenses and liabilities at same time. It is a matter of perservering and sooner or later, one will reach financial independence should his income producing assets be able to produce passive income enough to cover all his expenses and liabilities. By then, his monthly cashflows will become consistently positive without his effort in producing active income and he is thus financially free.

To reach this goal, it does not mean that all people should quit their paying jobs. Before one can own substantial income producing assets, he needs an income source from his job to fuel his investment in income producing assets. So, it is time to rethink carefully whether one is really financially stable with a paying job? Most people are caught by greed and fear and so keep to their jobs (fear of no income) and seek improvements in their jobs or keep changing jobs to better their active income source (greed of wanting to increase active income). However, all these may not be comparable to a more financially stable source of passive income from owning income producing assets (yes, the more of such assets the better).

A final word to clarify that I am not proposing that people should not work for a living. One should work diligently and there is nothing wrong with working hard for a living. Even if one is financially free, one should still work and contribute to other peoples' lives. It is a privilege to be able to contribute to other peoples' lives, be it using one's time or money.

A short excerpt of investment wisdom from Benjamin Graham

Benjamin Graham was the investor who during his time taught that investments should be approached by sound principles of analysis. He taught that it is possible to valuate investments to estimate their value by fundamental approach. Here, I include an excerpt from one of my readings of his writings from the book, "The Rediscovered Benjamin Graham, Selected Writings of the Wall Street Legend by Janet Lowe."

"Let me close with a few words of counsel from an 80-year-old-veteran of many a bull and many a bear market. Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that's the row you should hoe. If you're really good at picking stocks most likely to succeed in the next 12 months, base your work on that endeavor. If you can foretell the next important development in the economy, or in technology, or in consumers' preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination and by continuous testing of performance, that you have what it takes to produce worthwhile results.

If you believe - as I have always believed - that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don't be led astray by Wall Street's fashions, illusions, and its constant chase after the fast dollar. Let me emphasise that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.

But whatever path you follow as financial analysts, hold on to your moral and intellectual integrity. Wall Street in the past decade fell far short of its once-praiseworthy ethical standards, to the great detriment of the public it serves and of the financial community itself. When I was in elementary school in this city, more than 70 years ago, we had to write various maxims in our copybooks. The first on the list was "Honesty is the best policy." It is still the best policy....."

Graham has addressed a few issues by this sharing from a veteran investor. First, there may not be only one successful approach to investing. An investor can live out any investment philosophy he is comfortable with. However, whichever investing approach an investor chooses, he must not fall in love and be deluded with it's usefulness but instead test out rigourously whether the approach really yields success in getting consistent good returns on investments.

Second, investment success is not only exclusive to the selected experts in investment field (e.g. fund managers, financial analysts, or anyone with depth of training in the field of finance and investments). The qualities essential for investment success are reasonably good intelligence, sound principles of operation and firmness of character. Of course, an investor needs to learn first to acquire a set of sound operating principles and then have the tenacity to follow through the sound operating principles for investment success. As such, one has to be careful of any distractions that promises 'seemingly fast money' based on following certain 'dubious investing methods' unless that method has been already rigourously tested for it's consistent results.

Third and last, as financial analysts, one should handle his trade with moral and intellectual integrity. As such, this is also a warning for one to view any form of research reports related to investments with healthy skepticism and objectivity since one does not know the analyst(s) behind any research reports is(are) reporting based on upmost moral and intellectual integrity.

The Five Competitive Forces Driving Industry Competition (Part 3 of 3)

Here is a recapitulation on the five competitve forces driving industry competition to a perfectly competitive level based on my previous posts.

1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

I have provided a discussion on the first three forces based on my previous posts. I shall continue to provide a simple discussion on the last two forces namely, intense competition among existing companies in an industry and threat from substitutes of products or services.

Intense competition among existing companies in an industry

Existing companies in an industry are always in a state of competition for market share and profits. When competiton gets more intense, the rate of returns in an industry decreases. This is due to companies competing on the prices of their products or services, increased marketing efforts, increased costs of researching to come up constantly with innovative and better products one step ahead of their competition.

When an industry is not dominated by any leaders, competition may be more intense resulting in price wars. In an industry that has an established leader with dominant market share, the leader may have strong influence on product prices and is able to lead it's other smaller competiton to establish product prices in an industry. An industry that has less vigourous competition is considered a stable industry with relatively stable product prices.

There are some factors which promote intense competition in an industry as follows:

1. Many equal strength competitors: In an industry where there are many equal strength competitors, intense competition may take place as companies compete for market share and profits. Such intense competition is beneficial to customers in an industry, but not for the competitors as it drives down rate of return in the industry. On the other hand, an industry with a dominant player or some extent of coorperation among companies will result in less intense competition and help to increase profitability in the industry.

2. Slow growth industry: An industry where growth is slow will promote more intense competition among companies to compete for sales. On the other hand, in a fast growing industry, companies can increase their sales without necessarily taking away sales from their competition.

3. Capital intensive industry: In a capital intensive industry, companies need to have high turnover in sales to maintain profitability. As such, competition may intensify as companies reduce prices to achieve high turnover in sales. Examples of such industries include paper and steel manufacturers.

4. Commodity type products: If products or services in an industry is commodity-like (every company is selling similar undifferentiated products or services), companies will compete intensely based on prices and additional services provided to their buyers. This will drive down margins and rates of return in the industry. Examples include sellers of bricks, cement, food crops and fertilisers.

5. Companies can only increase their capacity in large steps: In industries whereby companies can only increase their capacity in large steps (e.g. by building large scale plants each time), this will result in tendency for more intense competition as rival companies reduce their prices to compete against a significant increased capacity (from periods of sudden significant increase in supply) in the industry each time.

6. When different companies in an industry have different strategies and objectives: When companies in an industry have very different strategies and objectives, there is less likelihood for coorperation and understanding between companies and thus more intense competition. In such environment, it is harder to establish a set of game rules whereby companies in an industry can play by to earn high returns since every company is doing their own things. For example, some companies may be willing to accept lower returns seeing the industry as only part of a wider strategy of their overall businesses while others try to gain maximum returns seeing the industry as a cash-cow.

7. High barriers to exiting an industry: In a low return industry, it make sense that companies should exit such an industry. This will reduce the supply in the industry and benefit remaining companies. However, there are many possible barriers to their exit and thus many companies stay on despite low returns in an industry. This continues to promote competition and depress returns in the industry of low profitability.

One possible barrier to exit is that companies in a particular industry may have invested in high cost and specialised assets (e.g. production plants specific to the industry and cannot be used in other businesses) and it will be uneconomic to stop the business running even if such existing business has low returns.

Another barrier may be a high cost in exiting an industry for certain companies. Some companies may need to pay some forms of compensation to their employees, customers and suppliers upon closing down the business. Some businesses may be bonded by contracts to service their employees by retraining and reassigning them new jobs, and also to continue providing after-sales service to customers even after closing down the business. Thus, the cost of exiting is high.

Another barrier to exiting is the incurring of strategic loss to the company. A business segment in a company may be underperforming, but the company may be reluctant to close down the business segment if the business helps to boost the overall image or quality of the company's relationships with it's customers, suppliers or government. Also, an underperforming business segment may share facilities with other business segments and it will be uneconomic to close down the underperforming segment. The underperforming business segment may be an important link in a vertically integrated chain. Example, oil companies have different business segments in a vertically integrated chain such as oil exploration, oil extraction, oil refinining, and oil retailing. Even if one segment for example, the oil retailing has low returns, the company may still keep it for wider strategic objective.

Another barrier to exit is because of emotional reasons. Some managers of businesses have spend much effort and time to build a business over years, and they have form an emotional attachment to or pride over their businesses and so find it difficult to close down the underperforming business. While other managers find it difficult to close down their underpeforming businesses so as not to affect families of employees who depend on the continuation of the business for their livelihood.

Another barrier to exit is due to government stepping in to prevent a low return business from closing in order to protect the welfare of the workers and community at large who depend heavily on the business for their survival or it's products and services.

Threat from substitutes of products or services

Companies in an industry may also face competition from threat of substitutes of their products or services. If another rival company can offer a different product that have similar functions to an existing product at a cheaper price, this will reduce returns for the company with the original product due to competition. The rival company may also offer a substitute product that is more expensive but has much better functions than the existing product in a bid to compete and replace the original product. E.g. the internet has now become a threat to certain retailers of goods as shoppers can buy their products over the internet instead of buying from retail shops. Thus, internet has become a threat of substitute of conventional retailing that reduces margin of some retailers.

In conclusion, an investor has to consider in his assessment of a company whether it is facing much intense competition with rival companies in an industry based on different possible factors promoting competition. Intense competition reduces returns in an industry. One also need to consider any potential threat from substitutes of products or services to an existing company to see whether the company has downside pressure to it's margins due to such threats.

The Five Competitive Forces Driving Industry Competition (Part 2 of 3)

I have mentioned in my previous post about five competitive forces (based on Michael Porter's work, Competitive Strategy, 1980) that drive industry competition to a perfectly competitive level. The five forces are as follows:-

1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

In my previous post, I have provided a simple presentation on his work on two of these forces namely bargaining power of buyers (customers) and bargaining power of suppliers. In this post, I shall present another competitive force, threat from potential entrants that also drive industry competition to a perfectly competitive level, restraining any company in an industry from achieving supernormal returns.

Threat from potential entrants

Any industry that shows better rate of returns than other industries (of similar amount of risks) will attract potential entrants into that industry. The potential entrants also want a portion of the pie in the lucrative industry. By having new entrants into the industry, the existing companies in that industry will meet with falling prices and rising costs of doing businesses when they spend more on marketing and extending favourable credit terms for customers, etc. to fight off increased competition and protect their market share.  
 
To slow down or put in check the advancement of new entrants, existing companies engage in two general strategies, putting barriers in the path of new entrants, and sending clear message to the new entrants that if they cross over a certain tolerance line they will be subjected to strong retaliatory attack until they are driven out of the industry.
 
Sending clear message of strong retaliation by existing companies should new entrants cross their lines 
 
The message of the threat of strong retaliatory attack by existing companies should new entrants cross their lines must be based on strong grounds to keep these new entrants at bay. To gain strong grounds on the message of retaliation, existing companies must show that they have defended agressively against past entrants into the industry. Also, existing companies must show they have a large amount of resources to fight off the new entrants (e.g. large cash reserves, strong borrowing capacity, strong working relationships with their suppliers and customers). Existing companies must also show they are strongly commited to the industry by having their assets mainly deployed within the industry.
 
Putting barriers in the path of new entrants
 
Existing companies in an industry can put barriers in the path of new entrants in the following ways:-
1. Having large economies of scale and scope: Existing companies that are operating at a large scale have the advantage of lower product costs since they are producing their products on an efficient scale. Smaller entrants are disadvantaged by incurring relatively higher product costs since their production is not yet on an efficient scale. Some existing companies may have economies of scope by being able to share their costs between different product lines (e.g. food manufacturers can add increased product lines making use of same distribution network and retailers). In order to compete against smaller entrants, sometimes larger existing companies may take advantage of their large economies of scale and scope to engage in price wars that will drain out the available financial resources of the smaller entrants when they try to keep up to the competition with the larger existing companies. 
 
2. Difficulty in imitation: It is not always easy for new entrants to imitate how existing successful companies are being run. For example, existing successful companies may already learn a great deal about their industry, their suppliers' and buyers' industries. They may also know how to reduce their cost of doing business by experience. All these technical experience and knowledge is a barrier to entry into the industry for potential entrants. 
 
3. Difficulty in accessing distribution channels: New entrants often find it difficult to break into existing distribution channels for their products. The existing companies in the industry would have established strong relationship with their retailers or buyers of products. New entrants may have to reduce the prices of their products in order to compete for retailers to carry their products or buyers to buy their products which is costly to the new entrants.
 
4. High switching costs for buyers: Buyers of certain products of existing companies may have high switching costs should they change companies to buy their products from. If the switching costs is high involving time and expenses in retraining their employees to use the new products offered by new entrants, buyers may not want to do a switch (e.g. hospital involving costs and time in retraining it's staffs to use medical equipment from a new entrant supplier). This puts the new entrants at disadvantage as they have to reduce their product price and introduce other significant attractive offers to convince buyers to do a switch which may not be easy.
 
5. Product differentiation and branding: Existing companies may have established differentiated product of strong branding offering high value for their buyers. It is not always easy for new entrants to compete against such strong brands and differentiated products. E.g. A new entrant carbonated beverage company will find it almost impossible to compete against established companies like Coca-Cola or Pepsi-Cola to gain market share even after draining large financial resources in research, marketing and distributing their products.
 
6. Government legislation and patents: Government legislation may prevent entry into an industry. This may protect the existing company/ies from new entrants. For example, limited number of transport or private healthcare companies in a country. Patents can also protect existing companies (e.g. pharmaceutical companies having patents over their products have exclusive rights on the making, distribution and sale of their products).
 
7. Control over suppliers and customers: Some existing companies may have control over their suppliers to sell to them and customers to buy from them (e.g. certain retailers may have strong power over their suppliers to sell through them). This makes it difficult for new entrants to compete against existing companies to persuade suppliers to supply to them or buyers to buy from them.
 
For an investor, he may check whether his invested company has a strong competitive position and economic moat by the ability to send clear credible message of retaliation to potential new entrants into it's industry or put barriers to stop or slow down the advancement of new entrants.

The Five Competitive Forces Driving Industry Competition (Part 1 of 3)

Through my research, I came across a discussion on the five competitive forces driving industry competition (based on Michael Porter's work, Competitive Strategy (1980)). These forces drive returns in an industry to a perfectly competitive level, thus constraining any companies in an industry from achieving supernormal returns. As such, managers of companies have to constantly battle against these five forces to gain a competitive edge in an industry, thus steering their companies away from the perfectly competitive level.

These forces are:-
1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

I shall provide a simple discussion on two of these forces namely "Bargaining power of buyers (customers)" and "Bargaining power of suppliers" in this post.

Bargaining power of buyers (customers)

Buying power provides customers the chance to negotiate for cheaper prices, ask for better quality on the products they are buying or ask for better and more services they are receiving. All these will squeeze margins of companies in an industry.

There are different situations whereby buyers in an industry are in a strong bargaining position. This is disadvantageous to the company which is selling it's products or services in the particular industry. The different situations advantageous to buyers arise as follows when:-

1. There is concentration of buyers: It is disadvantegous to sellers of products if the number of buyers is lacking in the particular industry. The worst case is many sellers trying to sell their similar products to only one buyer (monopsony). In this case, the sole buyer has a strong bargaining power over the many sellers and the sellers in a bid not to lose businesses may coorperate with the requests of this buyer.

2. Product is undifferentiated: If many companies are selling similar undifferentiated products to their buyers, buyers of the products may take chance to negotiate for cheaper prices and better services. Buyers may also play one company against another to negotiate for better prices and services. Such cases are found in commodity types of products, e.g. raw materials, food crops whereby buyers are in strong bargaining position over the many sellers of commodity products which are undifferentiated.

3. Product takes up a large cost for the buyer: A buyer is more aggressive at negotiating for cheaper prices on products that are costly to them. This is disadvantageous to the sellers. On the other hand, a buyer of small cost or one-off purchase products may not be as price-sensitive.

4. Buyer has low switching cost: A buyer that can easily switch suppliers with minimal costs of switching may be inclined to do so if another supplier offers better prices for similar products and services. Of course, switching suppliers also involves breaking a long-standing relationship with an existing supplier which is a consideration the buyer has to think over carefully.

5. Buyer is concerned with cost-cutting: A buyer that belongs to a company or industry that has high cost of doing business is sensitive to cost-cutting. As such, the buyer will be inclined to negotiate for cheaper prices on products and services from it's suppliers. The buyer may even at extreme case threaten to close down their business due to reason of high cost, thus in turn threatening the supplier with a discontinuation of their business with the buyer. This is especially significant when the supplier depends heavily on the sale of their products to the particular buyer who is threatening them.

6. Buyer can make the products themselves: Sometimes, a buyer may have the expertise to make the product they are buying from a supplier. As such, the buyer may threaten the supplier asking for better prices on the product they are buying, failing which they will not buy from the supplier but instead make the product themselves.

7. Quality of product buyer is buying is of low importance: A buyer that is not particular about the quality of a product may choose to shop around different suppliers for better prices. This gives bargaining power to the buyer over the suppliers. On the other hand, a buyer that is sensitive to the quality of a product may be less price-sensitive and willing to even pay a price premium for quality products. For example, a hospital will be more focused on quality of medical equipment purchased over prices.

8. Buyer has information on their suppliers: A buyer that knows about their suppliers' margins, costs and order books will be more prepared when negotiating for purchasing prices on products. Such informed buyer will be less likely to be taken advantage by overpaying for products sold by their suppliers.

Bargaining power of suppliers

Even as buyers have strong bargaining position based on the above discussed situations, suppliers can also tip the scale in their favour when the following situations arise. Thus, suppliers of goods/ services facing the following situations can command better prices for their goods/ services and thus better margins.

1. There is concentration of sellers: When there are not many sellers around with many buyers, the sellers have a significant advantage over their buyers. An example is Coca Cola company whereby they have the most significant market share for their products. There are many eager buyers (retailers of Coca Cola products) including fast food chains, restaurant chains, supermarket chains and other local franchises. Thus, the seller (Coca Cola) can negotiate for better prices and terms from it's many buyers (retailers) to carry it's products since there is only one seller (Coca Cola) selling their famous branded carbonated beverage (the coke) to many buyers competing to carry the product.

2. The product is unique and has strong branding: A seller selling a unique product (that has no substitute) has bargaining power over it's buyers since the buyers can only buy from one seller. For example in the local context, we have the unique local newspapers produced from SPH. Of course, there are also other considerations such as regulations from governments and authorities that may prevent a particular company in a particular industry from exerting it's dominance over prices of it's unique products especially if the product is widely used.

3. The supplier can supply it's products over many different industries: The supplier that can supply it's products/ services which are used over many different industries can have a strong bargaining power for the price of it's products/ services. In such case, the supplier can choose between many buyers from different industries that use it's products and so being able to bargain for good prices over it's products/ services.

4. The product supplied by the supplier is very important to buyer: A product/ service provided by a supplier that has great importance and is critically essential to the survival of the businesses of it's buyers will allow the supplier bargaining power over it's buyers on the price of it's products/ services.

5. The supplier can take over the operations and tasks of it's buyers: If a supplier can threaten to easily take over the operations and tasks of it's buyers in their industry (forward integrate into the buyers' industry) and enter as a potential competitor to it's buyer should the buyer not coorperate with the requests of the supplier, the supplier may have a strong bargaining power for the price of it's products/ services over it's buyers.

6. There is high switching cost for the buyers: When there is high switching cost for buyers of a product supplied by a particular supplier, the supplier will have strong bargaining position for the price of it's products/ services. For example, a hospital that buys medical equipments from a particular supplier may not easily change it's supplier since it may involve high cost of switching in time and expenses on retraining it's medical staffs to use new different medical equipment from another different supplier.

As one can see, the situations for strong bargaining power of suppliers is a direct contrast to the situations for strong bargaining power of buyers. It is important to know the relative bargaining powers of a company as both a supplier of it's own goods/ services and buyers of goods/ services. For an investor of a company, one can look out for his invested company to have strong bargaining powers both as a supplier and buyer. This may help to provide a better competitive position and margins for the company.

My stocks portfolio (as at 30 Nov 2009) - Focusing on the long term underlying businesses of my stocks

This month of November has been an interesting month of seeing the advancement of STI index with the surge of prices of mainly blue chip stocks while penny stocks and S-chips remained muted with some pull backs. As such, most of my counters (some blue chips) were up. There was also news that Singapore has declared itself out of recession. However, at the end of November came the news of the Dubai's debt crisis which jolted the global stock markets. Singapore stocks market was not spared as the STI closed lower this Monday (30 November). There were some commentaries stating that the Dubai's debt crisis will be under control and will not have far reaching effects.

On a personal level, my portfolio saw some adjustments to one of my investments (MacarthurCook Industrial REIT). MacarthurCook Industrial REIT (MI-REIT) went through an EGM to approve some resolutions on a proposed recapitalisation exercise. It received heated disapproval from one of it's substantial unitholder Cambridge Industrial REIT regarding it's recapitalisation exercise stating that the exercise will destroy unitholders' value significantly in the REIT. I took the chance to partially divest from this investment to avoid being caught in the significant dilution of my investment in the REIT. I have shared my thoughts on the recapitalisation exercise of MI-REIT in an earlier post (http://jeremyowinvestingexperience.blogspot.com/search/label/MacarthurCook%20Industrial%20REIT%20%28MI-REIT%29). Readers can follow the post for more details on this recapitalisation exercise. I did not fully divest from this investment as I still see potential for further positive developments with the incoming of new strategic sponsors and investors into the REIT despite the massive destruction of unitholder value.

Of course, I will need to continue monitoring the future developments of this investment. As such, I may rebuild gradually my investment in MI-REIT if the future developments in this REIT are good. I am not going to marry this investment, but is still interested to look out for it's future developments and should things turn out wrong, I will not hesitate to divest my remaining investment in this REIT for other better alternative investments. Thus, I am all out to invest focusing on the long term potential of the underlying businesses of all my investments and not be short-sighted, focusing only on short-term hicupps along the way. My investment in MI-REIT is a good lesson of not wanting to be a stock owner but a business part-owner still looking out for it's future developments and not run away totally just because of an immediate dilution of unitholder value. My investment motto goes ,"Constant monitoring focusing on long term economics of underlying businesses of stocks."

My stock portfolio saw an increase to the realised gains (increase by $2202.40) over this month due to gains on divestment of MI-REIT. My total transaction costs went up slightly because of the trading costs on my partial divestment of MI-REIT. My portfolio cost is reduced to $85,630.10 due to the partial divestment as well. All in, my total gain (%) over my portfolio cost is 52.85% which is a slight improvement from last month (total gain of 47.53%). I will receive dividends from two of my investments (MI-REIT and Tat Hong Holdings) in December, of which I will include in the dividends amount received under my December portfolio update.

My portfolio cost saw a decrease due to my partial divestment of MI-REIT. As such, the market value of my portfolio also saw a corresponding decrease.

My portfolio continues to see an improvement reaching a total gain of 52.85% over portfolio cost. This is due to unrealised gains over most of my counters influenced by improving sentiments to the better economic outlook as Singapore declared itself out of recession and the continuing gradual global economic recovery.

My realised gains has increased slightly due to the partial divestment of MI-REIT this month. My total transaction cost also increased slightly due to associated trading cost for this partial divestment. Overall, my total net gains increased slightly from $44,623.49 at 30 October to $45,261.80 at 30 November.

Moving forward, I will continue to monitor the companies under my portfolio. I will be sharing more of my own background research into the companies under my portfolio. Eventually, I hope to provide extensive sharing on the individual companies under my portfolio.

Once again, I wish all readers a happy and fruitful investing journey! :-)

Looking at liquidity (short-term financial health) of a company

I have discussed in an earlier post on "cash conversion cycle" as an important determinant of a company's short-term financial health (see http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html).  Cash conversion cycle is an important yet often overlooked metric in assessing a company's short-term liquidity (working capital position). Why is it important to look at a company's short-term liquidity? It tells us the short-term financial health of the company, whether it has a positive working capital position.

Working Capital = Current Assets - Current Liabilities

It is important for a company to have a positive working capital position so that it's current assets can meet it's current liabilities (over a one year short-term period). If the current assets of a company is not able to meet it's current liabilities, a company will have to raise cash (by employing debts or other forms of capital raising) to meet it's current liabilities failing which in most drastic case may mean bankruptcy for the company.

Types of current assets and their amounts held by a company can influence it's liquidity and short-term financial health

There are various items that are considered as current assets that can be converted to cash in a one year short-term period (e.g. cash and cash equivalents, equities held for trading or sometimes called marketable securities or short-term investments, accounts receivables and inventory). The breakdown of all these current assets held by a company can be found under it's balance sheet statement.

It is important to understand how each of these types of current assets can affect the company's short-term financial health. Cash and cash equivalents are the most liquid of all the types of current assets that can be converted readily into cash to pay off current liabilities. Next in order are equities held for trading or any equivalent short-term investments that can be readily converted into cash. Accounts receivables are also fairly liquid depending on the estimated number of days a company needs to wait to receive payments for their goods sold or service rendered. Inventory is the least liquid assets held by a company because the company has to go through the entire process of selling and waiting for payments on the goods sold.

Thus, it is important to evaluate carefully the proportion of each type of current assets held by a company to determine it's short-term liquidity and financial health. A company may have a much higher total current assets than it's total current liabilities. However, if a substantial proportion of the current assets consists of inventory, it maybe quite worrying should a company not be able to sell it's goods under the inventory held. If a company has a trend over the years of high amount of assets held in it's inventory, this maybe a red flag for greater financial problems to come especially if the company also has a poor "cash conversion cycle" (high number of days required for the entire cash conversion cycle). All these may suggest difficulty in selling the company products and the company also has difficulty in collecting payments from products sold if the cash conversion cycle is poor. A high amount of current assets held in inventory may not always necessarily be a bad sign provided the company has an excellent cash conversion cycle.

Based on the order of liquidity of the various types of current assets, it may suggest that a higher amount of current assets held in cash and cash equivalents is best since it can be most readily converted into cash to meet the current liabilities. This is true only to a certain extent. If the company has a trend of having too much assets held in cash and cash equivalents, it may also suggest that the company is unable to deploy it's cash to productive use to grow it's business and make meaningful returns.

Thus, when evaluating any types of current assets, similar to evaluating any single metric of measurement, one has to be careful not to make any sweeping mistakes in judgment by not considering other metrics of measurements together in order to see the big overall picture of a company's investment worthiness. A trend of high amount of current assets held in inventory with a trend of increasing revenue, increasing net income, increasing gross and net margins and increasing positive cashflows may instead paint a good picture instead of a grim outlook based on making a biased judgment on looking at a trend of high amount of assets held in inventory alone.

Financial ratios to evaluate a company's liquidity and short-term financial health

When evaluating liquidity of a company, there are various financial ratios one can consider such as current ratio, quick ratio and cash conversion cycle. I have already discussed cash conversion cycle in my earlier post. I shall discuss current ratio and quick ratio, and then provide a comparison between these different types of financial ratios. All the figures used in the calculations of the financial ratios discussed below can be found under the current assets and current liabilities of the balance sheet statement. 

Current ratio

Current ratio is the simplest financial ratio to determine the liquidity of a company. It is also the most commonly used and stated financial ratio by analysts and investment firms. The current ratio only measures the short-term financial health of a company by considering whether its current assets is able to meet its current liabilities. Thus, a current ratio of more than 1 is preferred so that a company's current assets can meet its current liabilities fully. The shortfall with using this financial ratio is that it does not consider the types of current assets and their amount held as mentioned above. By using this financial ratio, one is assuming that all current assets can be readily converted into cash to meet the current liabilities which often is not the case (e.g. inventory that cannot be sold quickly or accounts receivables that cannot be realised quickly).

Quick ratio

Another financial ratio that considers only the more liquid assets that can be converted into cash to meet the current liabilities is the quick ratio. As seen in the formula above, inventory is not considered in the caculation since it is not easily converted into cash (offers least liquidity). As such, quick ratio is a more conservative financial ratio than current ratio when assessing the short-term liquidity and financial health of a company. A quick ratio of more than 1 is preferred so as to allow the more liquid assets to meet the current liabilities fully.

Cash conversion cycle

Cash conversion cycle is another way to measure a company's liquidity based on considering the days in inventory, days in receivables and days payable outstanding (see my previous post on cash conversion cycle http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is a better measurement of the liquidity and short-term financial health of a company by considering how fast the company sells it's goods held in inventory, how fast it receives payments for goods sold or services rendered and how long it can be able to delay it's payments to suppliers of goods. A company that can sell goods fast, receives payments fast and have sufficient time to pay it's suppliers has a shorter cash conversion cycle (in terms of shorter number of days) and thus a better liquidity and working capital position (ability to raise cash fast from it's operations) to meet it's currrent liabilities.

Thus, cash conversion cycle maybe a better and more critical way to measure a company's liquidity. Most often, it is a poor cash conversion cycle that drags down a company's liquidity and short-term financial health more so than the amounts and types of current assets held.

In conclusion, a careful investor does not base his assessment on any single metric alone. It is the overall assessment of a company based on many factors of consideration that matters because considering any single metric in isolation may result in an inaccurate judgement of a company's investment worthiness.

The Richest Man in Babylon

I recently borrowed an audio book from the library titled "The Richest Man in Babylon". I am currently expanding my research from investment to include financial planning as well. I am looking into financial planning skills as I believe that investment and financial planning (allocation of one's capital to increase productivity and security) go hand in hand. As such, I will seek to provide more research on these two areas of both investment as well as financial planning in my future posts.

In this audio book, I managed to pick up some important financial planning skills. This book presents an interesting look into old financial planning skills from ancient past of Babylon. Of course, the characters and story being told are fictitious. However, the lessons to be learnt are applicable to modern times. It told of a richest man in Babylon who gave a tablet containing important rules on money management to his son. The man also gave some gold to his son and sent him off to the outside world to test his ability to manage and grow the gold.

In two misadventures, the son nearly lost the entire gold given him by his father. The first misadventure spoke of the son believing in some travellers who told him to put a portion of his gold into a sure win gamble of a horse race. The son lost the gold put into the bet and only in the end found out the travellers were con men who were in cahoots with the few other competitors who bet against this son in the horse race. The son found out this from other travellers only when the travellers who swindled his money had left him.

In another second misadventure, the son heard from a travelling merchant that his merchant friend had a business selling pots and wares which is worth investing in. This travelling merchant managed to convince the son to buy over the business which he persuaded the son that it is a good investment on his gold and he would make many times returns over his invested gold. After the son bought over the business did he realise that pots and wares were difficult to sell and he ended up with lots of junk pots and wares that were of little value and use.

After losing almost his entire gold did the son began to look at the tablet that his rich father had gave him. He began to study carefully the words of wisdom carved on the tablet by his father. It contained five important money management rules.

Rule number one said that "one should seek to invest wisely not less than one-tenth of his regular income consistently for compound interest to work".
Rule number two said that "one should always seek profitable employment (investment) for his money in order to grow it".
Rule number three said that "one should seek the advice of wise man who manages and invests money prudently in order to learn from them, and one should also be cautious to never place his money in risky wager or gamble ".
Rule number four said that "one should never make investments that he does not understand or is unfamiliar with so as to protect his principal capital." 
Rule number five said that "one should never be caught by greed to make investments that promise returns that are far beyond any logical thought and should beware of tricksters who promise returns on investments that are unbelievable."

After the son has read the rules carefully and given much thought to them, he realised that only a person that has the right attitude towards money management will be able to grow his money prudently. It does not matter whether how much money he began with. To a prudent person, even a small sum of money can compound into a large amount given the right money management attitudes. To a non-prudent person, even a large sum can be lost through his hands resulting in nothing in the end. As such, the son regretted that he should have read the money management rules his rich father gave him first before even venturing his given money into any investments. He realised that it is the right attitudes in money mangement that really matters and not how much money he begans with.

With regards to the above five rules, it can be summarised into simple take home messages. We are not talking about being greedy in terms of accumulating and hoarding wealth. We are taking about managing our finances prudently so as to make meaningful growth in our savings and in turn using our money or money management skills to help others. Of course, helping others may not be restricted to only monetary means. As in one of my earlier post, one needs to look beyond just wealth as it is a perishable item that one cannot bring to the grave anyway.

Simple take home messages:-
(1) Invest as much dispensable income (portion of income one does not need in short-term) and returns from existing investments regularly to make meaningful growth of one's investments by compounding.
(2) Never gamble one's money. There is no basis for a sound foundation of returns by gambling.
(3) Be humble to learn from wise prudent people who manage their investments and finances well. 
(4) To protect one's capital, one should never invest in any investment that one does not understand the workings of the investment.
(5) One should be realistic about the returns one is getting from an investment. If an investment promises a return too good to be true, think carefully for it may really be "fleeting sweet promise". Invest therefore on a sound foundation of investment knowledge and not seek short-cuts.

To listen is always easy, but it is the discipline and perserverance that will allow only the doer instead of listener to reach his financial goals.

My thoughts on MacarthurCook Industrial REIT's fund raising exercise.....

At last, the EGM for MacarthurCook Industrial REIT (MI-REIT), one of my investments has been convened. I attended the EGM today and this happened to be my first time at an EGM after one year plus of investing journey. It was indeed an eye-opener for me at the EGM where I saw the exchanges between the unitholders and management of MI-REIT. I highly encourage serious investors to attend all AGMs and EGMs of their invested companies to update themselves on the developments of their invested companies,  voice out their constructive opinions on important issues to the management of their invested companies, and also to vote for any important resolutions to be passed during such meetings. Thus, such meetings serve as very important avenues for shareholders to meet the management, and exert shareholder pressure serving as a check to make sure management is still executing strategies that are beneficial to both the business and their shareholders.

There are altogether five resolutions to be passed at the EGM basically as follows.

(1) To approve the AMP Capital Investment
(2) To approve the Cornerstone Investments
(3) To approve the AIMS Investment (as part of the Cornerstone Investments)
(4) To approve the Rights Issue
(5) To approve the Acquisition of the AMP Capital Properties

Based on one of my earlier post, MI-REIT has term loans of S$226 million and JPY 1500 million (S$23.7 million) which needs to be settled by end December. It also has a contractual obligation to purchase an industrial property in Singapore (1A International Business Park) by end December which it requires around S$90 million.

MI-REIT has come out with a fund raising proposal which comes in a package to deal with the refinancing of the loans and purchase of the business park property. In this package, it has invited some institutional investors namely AMP Capital Holdings, a group of investors including AIMS Financial Group together called the Cornerstone Investors, and proposed a rights issue to raise funds to refinance it's debts. All the invited institutional investors will be offered the purchase price of $0.28 per unit for new units in MI-REIT. Rights units under the rights issue will be priced at $0.159 per unit. As part of the proposal, it has also proposed the purchase of 4 industrial properties from AMP Capital Holdings as part of the agreement for AMP Capital Holdings to invest in MI-REIT.

I present below some of the major issues that were raised by unitholders and also responses of MI-REIT to the issues raised. After that, I will present my own thoughts over this whole fund raising episode. Before I continue further, I caution readers that I do not guarantee the completeness or accuracy of my interpretation of the issues raised and responses to the issues by MI-REIT.

Major issues were raised by existing unitholders during the EGM as follows:-

(1) Why did MI-REIT waited so long (almost a year) to come up with a last minute desperate fund raising proposal (when the debts are due soon in December) that leaves existing unitholders with no choice but to accept this proposal or face winding up of MI-REIT?

(2) Is there no other better proposal except this current packaged fund raising proposal?

(3) Why are the invited instituitional investors (AMP Capital, AIMS Financial and other investors under the group of Cornerstone investors) offered new units ($0.28 per unit) at such a significant discount to the NAV of MI-REIT ($0.94 per unit)? Are the invited investors being opportunistic in nature?

(4) Why did MI-REIT not consider the sale of some of it's properties to raise funds to clear it's debts?

(5) Why must MI-REIT purchase the 4 properties from AMP Capital? Is it fair for MI-REIT that AMP Capital should insist the sale of it's 4 properties to MI-REIT as part of the agreement to act as a potential investor in MI-REIT?

(6) Why not consider winding up MI-REIT since it's NAV is high and unitholders may get back a good fair amount of compensation after liquidating MI-REIT's properties and paying down all it's liabilities?

(7) Is such a huge dilution due to the funds raising proposal (theoretical ex-rights price of around $0.22 per unit and ex-rights NAV of $0.32 per unit) justified for the interests of the unitholders?

Management of MI-REIT responded to the above major issues raised as follows:-

(1) MI-REIT has already been actively seeking out funding possibilities since the start of the year. However, all potential lenders or institutional investors require an interest return of 25 to 30% which is too much for MI-REIT to accept as favourable. Basically, under such negative circumstances faced by MI-REIT, it has no bargaining power over it's potential lenders/ investors. As such, the management thinks the current proposal is the best and is not a last minute thing, after much sourcing for funding and consideration.

(2) Mangement thinks there is no other better solution after much sourcing for funding and consideration, except to accept the whole proposed fund raising package for the interests of the unitholders.

(3) Mangement expresses that it is necessary to come with an agreement with the potential investors to offer new units at such attractive price of $0.28 per unit to ensure the fund raising exercise will be successful as the investors will also sub-underwrite the rights units being offered. All in, this ensures the REIT will obtain it's funding to refinance it's debts.

Management thinks the potential investors AIMS Financial Group and AMP Capital Holdings will serve as strong sponsors to MI-REIT once they have a substiantial stake in MI-REIT after acquiring new units in MI-REIT. Both these investors are some of the leading investment companies in Australia and they have exposure and experience in real estate and fund management in China, Japan and Australia. They will be catalysts in helping MI-REIT source for and acquire good industrial properties in such regions out of Singapore which is in-line with MI-REIT's original growth strategy of investing in industrial properties in Asian regions. Thus, management thinks these investors are not opportunistic and on the contrary will benefit MI-REIT to have them as it's future sponsors.

(4) MI-REIT has considered but will not sell any of it's properties as it's total debts and obligations are too large (around $320 million) to be meaningfully met by the sale of some of it's properties (total of it's estimated property value only round $500 million).

(5) MI-REIT thinks that it is necessary to accept the purchase of the 4 properties from AMP Capital as part of the agreement so as to secure AMP Capital as one of it's potential investor and future sponsor which will provide future benefits to MI-REIT and it's unitholders. Somemore, the total purchase price of the 4 properties is fairly priced (according to two independent property valuators) and the properties are also yield accretive.

(6) Management thinks winding up MI-REIT is not a viable option and is disadvantageous for it's unitholders. In the event of winding up, the properties will be in the hands of a receiver (e.g. a bank) and the receiver will try to sell the properties as quickly as possible at firesale prices which means the amount to be returned will be much lower than the total current value of all it's properties. Furthermore, the total debts and liabilites need to be cleared and after clearing all debts and liabilities, it may mean little amount or even no compensation to be returned to it's unitholders. Thus, winding up is never an option at all as it may result in total loss of it's unitholders' investments in MI-REIT.

(7) Such significant dilution due to the fund raising exercise according to management is not good for it's unitholders. However, management expresses that it is necessary to do the fund raising to ensure the continuity of MI-REIT. This will settle all refinancing until year 2012 and will put MI-REIT at better grounds financially for possible expansion (by acquiring properties) into other Asian regions given the support from the new sponsors which have experience and expertise in estate and fund management in other Asian regions.

My thoughts on the whole fund raising episode by MI-REIT

My opinions are mostly aligned to MI-REIT's managment responses to the major issues raised during the EGM. A fund raising exercise like this, though resulting in significant dilution, is necessary to the continuity of MI-REIT.

NAV per share is NOT a guarantee to one's investments

I am not in favour of the winding up of MI-REIT as this may mean total loss of unitholder investments in MI-REIT. Many investors have the misconception that Net Asset Value per share (NAV per share) is like a magical number that guarantees their investment value in a company. In investments, there is nothing guaranteed. In the event of liquidating the assets of a company due to winding up the company, the assets usually sell at ridiculousy low prices over a short-time period so as to raise cash fast to pay the debts due and other forms of liabilities owed by the company. So, NAV per share is just a very rough estimate not to be taken too seriously. Seriously speaking, NAV per share DOES NOT guarantee the investor will get back this NAV per share amount upon liquidating all assets and paying all liabilities. Thus, I learn this big lesson over the MI-REIT's episode. Nothing is guaranteed in equity investment (unless there is any insurance company willing to insure an investor's investments??). Always be very careful when investing. As such, I had partly divested out my investments in MI-REIT to recover back my invested capital in MI-REIT before attending the EGM.  I did this not because I have no faith in the fund raising exercise by MI-REIT. I wanted to protect my capital as anything can happen should unitholders not vote in favour of the resolutions during the EGM. As Warren Buffet's most important investment rule goes, "Never lose money". Preservation of capital is the most important investment rule that all sound investors hang on to carefully.

Most investors are short-term oriented or should I say short-sighted?

With this fund raising episode, I can see that most investors are very much concerned about the dilution effect due to the fund raising exercise. I can understand and emphatise with many investors on the dilution of their investments and reduction of distribution yield. However, should an investor be only concerned about the returns of an investment and ignore anything else including the fundamentals of the invested company. I quite agree with MI-REIT management's viewpoint of getting in AIMS Financial Group and AMP Capital as strategic sponsors to benefit the REIT going forward. Of course, nothing is guaranteed as to the future growth of MI-REIT with these new potential sponsors. However, at least the immediate benefit is that MI-REIT is able to raise funds from these new potential sponsors to clear it's debts and ensure continuity of it's business. I am for the long term growth of a company and if having these sponsors can potentially help MI-REIT in it's future growth, the question is why not? I think as investors, we need to have a long term outlook and not just be caught up with short-term gains. Returns on investments though are important, one also need to consider that returns come from underlying business of an invested company. No good business equals to no good returns. If MI-REIT can strengthen it's balance sheet and have strategic growth plans going forward, why not give it a chance and not quibble over a temporary drop in distribution yield or NAV? I think that even investors sometimes can act like small children quarelling over who gets more and who gets less over a short-term period. Be long term business oriented and not short-sighted money oriented.

Protection of capital by value investing

Again, holding MI-REIT's units at low average price (around $0.30 per unit) substantially lower than it's NAV of $0.94 per unit allowed me the chance to partially divest out of it to recover my capital thus preserving my capital. If I had purchased my units at higher prices, I may have to bear a loss upon divesting out at current market value (which an investor has no choice but to do so should a company is on the road to bankruptcy). Thus, value investing by purchasing equities at undervalued prices again allowed me the chance to protect my capital by divestment upon possible mishaps to a company (I had earlier divested out of another company Jaya Holdings also by virtue of value investing).

Final conclusion

I certainly hope that MI-REIT can survive this ordeal and emerge stronger clearing it's refinancing and also with the new sponsors in it's management. Much leaves to the future of MI-REIT even if it pulls through this ordeal. It still have to prove itself by expanding over the Asian regions if the new sponsors come on board with their regional experiences and networking. If it pulls through, I hope it can learn a good lesson from this episode and be prudent with capital management and risk going forward. Expansion is always good for any company or REIT. However, it will not be good if expansion puts the company/ REIT in a precarious financial situation. I still subscribe to the notion that a business that can enjoy good growth and returns by using mostly retained earnings to reinvest and not employing much debts is the best around. Even better if it's rate of growth and returns is higher than it's competition under such conservative capital management and ideal economics that does not require funding of growth by large amount of debts.

What is financial independence?

I attended a seminar recently which speaks about entreprenuership. I attended the seminar because I wanted to find out more about how to set up businesses as I may be interested to set up my own business in future. The speaker spoke passionately about her experiences with helping many people and organisations set up and run businesses effectively. The speaker also questioned the audience about their reasons for wanting to be an entreprenuer. One common reason given by many on why they would want to set up and run businesses is to reach financial independence.

I managed to reach a better understanding of what is financial independence based on the speaker's explanation. The idea of financial independence to me before hearing from the speaker used to be the ability to receive passive income for living without the need to work. However, my idea of financial independence is partially faulty. Financial independence is the ability to receive consistent recurring passive income that is more than able to cover total personal expenses (including all liabilities and loans), thus allowing the individual the luxury not to work anymore. Thus, the person is in a state of being financially free and working becomes an option and not a necessity for him anymore.

Can a person who has reached financial independence return back to the state of being financially burdened again? Yes. If the passive income is no longer able to meet the total personal expenses anymore, the person returns to the original state of needing to work again to meet his personal expenses. Usually, for ease of discussion, one can look at total monthly passive income versus total monthly expenses. As long as one's total monthly passive income is more than total monthly expenses, and this state is able to be maintained indefinitely, the person has reached a state of financial independence. Assuming there is no change to his amount of passive income and amount of expenses, this state of financial independence will be maintained.

So, financial independence simply means:-
Total recurring monthly passive income greater than or equal to Total recurring monthly expenses

It is not difficult to reach financial independence. Two points must be reached and maintained as follows.

1. There must be a stable consistent passive income source(s).

2. The amount of this monthly passive income must be greater than or equal to the total monthly expenses.

Thus, theoretically speaking, if one is a person whose recurring monthly expenses is little and he has stable recurring monthly passive income source(s) able to meet his total monthly expenses, he would have reached financial independence. The longer this state can be maintained, the longer the person need not be burdened with the necessity to work anymore.

Why is it that not many people can enjoy the luxury of consistent financial independence? 

A few reasons could be possible.

1. The passive income source(s) is/are not stable.

2. The amount of passive income keeps fluctuating, sometimes below and not able to meet the expenses.

3. The amount of monthly expenses keep changing and usually is getting larger and larger so that the monthly passive income can no longer fulfil the increased expenses (possibly with changes in lifestyle and commitments).

Final conclusion

It is many peoples' dream to reach financial independence. There is nothing wrong with aspiring towards this state. However, one must be careful that once he reaches financial independence, what will he do with his freed up time that he no longer need to work anymore. Invest his freed up time to enagage in meaningful actvities to help others or just while it away in meaningless pursuits? This is a question to consider carefully since one has only a lifetime to live and spend his life after which all humans must meet death eventually (whether by natural or unnatural death).

Investment Learning Points

Dear readers,
I am shifting all the investment learning points from the sidebar of my blog into this dedicated post so as not to overcrowd the sidebar of my blog. This is also to allow further updating and expansion of my investment learning points in this post as my investment experience grows. Please return periodically to this post for updates on my investment learning points. I wish all readers a fruitful investing journey!

INVESTMENT LEARNING POINTS

Investment techniques

Focused investing:- Invest heavily in only a few stocks (10 stocks or lesser) that are perceived to be most promising.

Value investing:- Invest in stocks only when their price is below their intrinsic value to pay less than what the shares of a company is worth, and achieve greater returns.

Cut loss:- Short-term investors should adopt a strict cut-loss measure to sell out shares that have decreased by a certain pre-determined amount in price to prevent incurring huge loss.

Emotions kill at investing.  

Never catch a falling knife.

It is difficult if not impossible to accurately time a market bottom.

It is always prudent to analyse business fundamentals underlying a stocks before purchasing the stocks.

Average down only when stock prices are already significantly undervalued. Never average down on a free falling bear market to prevent catching a falling knife.
 
Cheap price may not mean value buy. Always check for any permanent problems with underlying business of stocks to make sure one is not inheriting a failing business.

For a diversified investment approach, an investor can consider exchange traded funds (ETFs).


An investor should live out an investment philosophy suitable to his personality so as to make investment decisions based on his philosophy and not emotions.

Avoid rebalancing of one's portfolio. Have the courage to ride the winners and weed out losers constantly.

Avoid high turnover in trading one's portfolio. Transaction costs is a drag to investment returns.

Value investing provides a protective margin of safety.


An investor may misjudge a company's intrinsic worth, so he should always seek to invest at share prices below the estimated intrinsic value per share of a company to gain a margin of safety to account for possible error in overestimating intrinsic worth of a company.

Buy-and-hold strategy can work well if an investor has applied it properly knowing when to buy, when to hold and when to sell a stock or investment product.

Compounding is an amazing effect that serves to grow an initial investment many times over in value through reinvestments. The higher the compounded annual rate of returns and the longer the time period of compounding, the higher will be the final value of an initial investment.

The stock market is not always efficient. Prices of stocks can be traded at ridiculously low or high valuations at times.

The stock market is random. Stock prices may not always follow through trends and can change suddenly. Make use of market price fluctuations to one's advantage.

Valuation techniques
 
Hunt for stocks with high current and future projected yields on investment:-
Take current EPS divide by current share price and multiply by 100% to calculate current yield. Take future projected EPS (after certain number of years) divide by current share price and multiply by 100% to calculate future yield. That will be the future yield of returns on an investor's investment dollars.

One can estimate the intrinsic value of a company by using the discounted cashflow method (DCF method). This valuation technique assumes that a business is worth the present value of all it's future projected cashflows. A note when using the DCF method is that future cashflows are only estimates and the estimated intrinsic value per share of a company using DCF is ONLY an estimate at best. Thus, value investors should invest at a margin of safety below the estimated intrinsic value per share of a company.

Fundamental Analysis

Free cashflow = Net cash from operating activities - Capital expenditure

Look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and has consistent high return on equity (ROE).

Ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.

Return on equity (ROE) is an important metric for measuring a company's profitability. Consistently high ROE (15% or more) for many years of a company's operating history is desirable. An investor should also take note of a company's financial leverage when using ROE to make sure a company is not risky by taking on excessively high amounts of debts.

It is important to examine trends in the financial statements of companies over a period of time (e.g. last 5 to 10 years) to uncover any consistency or inconsistency in the economics of a business. A one-off recent spectacular performance by a company may not necessarily indicate consistency to perform in future. Similarly, a one-off recent underperformance may not necessarily indicate permanent deterioration in business fundamentals. Be aware of non-recurring exceptional items in any financial statements that may undermine or overestimate a business's true economics. Always look for possible consistency in the business fundamentals and make sure the consistency is still intact.

Net asset value (NAV) per share also known as book value per share or equity value per share is the value of a company's assets less the value of its liabilities.

Net asset value (NAV) = Total assets - Total liabilities
It is a misconception that shareholders of a company should get back the NAV per share worth of compensation upon winding up a company. This is because assets of a company may be sold at lower firesale prices than its carrying price stated in financial statement upon winding up the business. Shareholders may get back lower than NAV per share value of compensation or even no compensation upon winding up of a company after it has paid off all liabilities.

One should consider the liquidity of a company to evaluate it's short-term financial health. To do so, one can consider the types and proportion of current assets held by the company such as cash and cash equivalents, short-term investments (e.g. equities held for trading), account receivables and inventory. Cash and cash equivalents are the most liquid current assets that can be readily converted into cash while inventory are the least liquid current asset that is most difficult to convert into cash. The company that can readily convert it's current assets into cash will be able to meet it's current liabilities ensuring good short-term financial health. 

To assess the short-term financial health of a company whether it has current assets able to meet it's current liabilities, one can look at a few financial ratios and calculations such as current ratio, quick ratio and cash conversion cycle.

REITs investing

When investing in REITs, do not just focus on annualised distribution yield alone which can be misleading since it changes according to the REIT's traded unit price which can fluctuate. Instead focus on core fundamentals such as:-
- performance of trends of growth over the years in the amount of income distribution to unitholders, rental revenue and net property income.
- average income yield of properties in the REIT,
- occupancy rates over the years,
- track record in refinancing loans on time,
- gearing of less than 40 plus %,
- diversified rental income sources from different types of tenants,
- built-in rental escalation,
- security deposits on rental,
- long average rental lease period to expiry,
- no large number of rental leases (expressed as % of gross rental income) expiring over any single year,
- no significant overcontribution from a single tenant,
- honest and capable management that are shareholder friendly,
- interest coverage ratio of more than 1.5,
- low interest rate on borrowings, 
- consistent growth in EPU and DPU (examine carefully the reason if there is a dip in EPU and DPU for a particular year).
Also seek to invest significantly below the NAV of the REIT to gain a margin of safety.

Rights issue

Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares.

Look for rights issues that are supported by full underwritting from an investment bank. This ensures that the company / REIT raising the rights issue can obtain it's funding regardless of whether the rights shares/ units are eventually undersubscribed or oversubscribed.

Theoretical ex-rights price is an estimated stock price after factoring in the effect of the rights issue. One can use the theoretical ex-rights price to compare with one's eventual average holding price after purchasing new shares through the rights issue to make sure one's eventual average holding price is not too steep above the theoretical ex-rights price.

Check carefully whether a rights issue consists of renounceable or non-renounceable rights. Renounceable rights offer existing shareholders the choice to sell their rights entitlement to other investors during the nil-paid rights trading period should they not want to hold the rights to purchase the new offered shares. This is so that existing shareholders that do not want to exercise their rights to purchase new shares can receive some compensation for the eventual dilution of their investment in the company.

To determine how much is the rights entitlement worth, take the difference between the theoretical ex-rights price per share and the rights issue price per share. An existing shareholder (who does not want to purchase new shares) should seek to sell his rights entitlement above this calculated rights entitlement value during the nil-paid rights trading period. On the other hand, a new investor (who wants to purchase new shares) should seek to buy at below the rights entitlement value for a bargain.

Be careful of companies that frequently raise rights issue only for paying down debts. This may signal problems with the financial health of the company. Rights issue is preferred for reasons such as fulfiling acquisition and growth plans. This ensures potentially increased future shareholders' earnings from yield accretive ventures.

Cash conversion cycle

Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).

Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding

Red flags to look at when assessing the cash conversion cycle include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.

One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.

Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.

Industry analysis

There are five competitive forces driving industry competition. These forces drive returns in an industry to a perfectly competitive level, thus constraining any companies in an industry from achieving supernormal returns. These five competitive forces are:-
1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

It is important to check whether a company has both strong bargaining powers as buyers of goods/ services and suppliers of goods/ services before investing in the company. Bargaining powers as buyers and suppliers affect the competitiveness and margins of the company.

To deal with the threat from potential entrants into an industry, existing companies engage in two strategies:
1. Sending clear message to the new entrants that if they cross over a certain tolerance line they will be subjected to strong retaliatory attack until they are driven out of the industry.
2. Putting different types of barriers in the path of new entrants.

An investor has to consider in his assessment of a company whether it is facing much intense competition with rival companies in an industry based on different possible factors promoting competition. Intense competition reduces returns in an industry.

An investor needs to consider any potential threat from substitutes of products or services to an existing company to see whether the company has downside pressure to it's margins due to such threats.