My stocks portfolio (as at 30 Oct 2009) - Does buy-and-hold strategy works?

Does buy-and-hold strategy works?

Warren Buffett has an investment quote, "We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely." Different investors have different investment philosophy. Not all investment philosophies are alike. Some thrive on constant trading while others like me subscribe to a buy-and-hold strategy. I respect different investment philosophies as there are successful practitioners
living out different individual investment philosophies making good returns on their investments.

As a focused value investor, I look out for sound fundamentals of companies to invest in. I also look at valuation of the company stock, to make my investment as far as possible at undervalued prices of a company's stock. I also adopt a buy-and-hold strategy to make the most out of my investment from the continued good growth and economics of a business. As long as a business is still worth investing in, I will remain invested in it to allow the long term economics of the business to increase the value of my investment over time.

Of course, a buy-and-hold investing approach does not mean marrying a stock though it seem to suggest from the persistence to hold onto a stock even through market fluctuations. The correct view to a buy-and-hold approach is that an investor remains invested in a business that is still performing in terms of business economics. Only when the business has deteroriated permanently in business fundamentals or the stock price of the business has been grossly overvalued so that the business's total projected cashflows over it's lifespan cannot justify for the high stock price being traded will an investor divest out of the business. A business will have it's business cycle (growth phase, maturation phase and declining phase). No business can remain forever. So, a buy-and-hold strategy looks at remaining invested in a business that is perceived to be able to generate a consistent successful excellent business economics over it's entire lifespan (the longer the business can continually perform generating good returns for it's shareholders, the better).

Thus, buy-and-hold does not mean being a stubborn mule bitting and holding onto a carrot and will not let go no matter what. If the carrot is spoilt or lost it's taste, it is prudent to part ways with it immediately and look for better carrots to bite. However, when the mule has found an excellent carrot, it will bite and chew and continue chewing slowly indulging in it's excellent taste for while the carrot can last until the last chew.

My portfolio results stem from a buy-and-hold approach

I have not done any trades during the month of October. Since there is no acceptable investment opportunity and ideas this month, I remain inactive. Adopting Buffett's quote above, I will wait patiently for investment opportunity. If nothing great appears on my radar screen, inactivity strikes one as intelligent. Anyway, I don't get paid for activity unless it is necessary to carry out a good investment idea. Only the brokerage firm gets paid for my activity.

My portfolio went through a mini-roller-coaster ride for this month. However, things have stabilised at least for the moment. As to the short-term forecast of the stock market movement ahead, I have no desire and interest to know. As long as my invested companies continue to do well in business economics, I remain invested in them. Market fluctuations are of no interest to me. Stock price fluctuations only allow me to decide when an investment opportunity has arrived or not. Stock price movements being characterised as "Mr Market" is my friend. I will entertain "Mr Market" and make friend with him only when he offers me an attractive price for an investment opportunity. Otherwise, I will only smile at him at best and say "call me again next time" when you have a better deal for me.

I did not receive any dividends this month from all my stocks holdings and since I did not make any trades, the realised gains remain stagnant at $8826.18. My total transaction costs remain the same as well (thankfully without any trades made). My portfolio has seen improvement in the unrealised gains allowing my net total gain (%) to rise to 47.53% on my portfolio cost (compared to last month's net total gain of 40.15%). So, does buy-and-hold approach works (considering I had bought and held onto most of the stocks in my portfolio for around a year already)? I think it is still too early to tell. I am still investing and researching based on my current portfolio on the possible merits of such a buy-and-hold strategy. I will continue to learn how to live out a focused value investing philosophy and see if it really works in practice. Let the research continue on........

Additional research information on my portfolio for this year

I only started to document my portfolio results from January this year. However, it provided somewhat enough information into the movement of the stocks market from the bear period a year ago through the sharp rally from early March until now. I view the stocks market ahead with anticipation. It is really fascinating to watch the everchanging dynamics of the market based on the combined psychology of all market players since I started investing. It is no wonder so much work and research has been done in the area of behavioural finance to document the thinking and psychology of market players. The human mind is really fascinating to examine when making investment decisions be it rational or irrational ones.

I shall present the following charts that document my progress in investment over this year.

The market value of my portfolio was below my cost of portfolio from January to April. This was due to the full sharp decline of the bear market felt from October last year to March this year. By holding onto my stocks and averaging down, I managed to have a low average price for most of my stocks (though my low average price for most of my stocks is still nothing compared to an investor who has entered during March this year). Well, those that can time the market bottom efficiently has already got their deserved rewards for their good judgment (based on hindsight) having been realised by the sharp rally following March. As for me, I may not have invested a substantially large part of my funds during March, but I certainly have caught a fair bit of investments from October last year to March this year adopting a value investing philosophy. The market value of my portfolio has exceeded my cost of portfolio from April until now thanks to the sharp rally and a buy-and-hold approach. Moving ahead, I do not know what will happen to the stock market. But, I will certainly still buy-and-hold cautiously, always looking out further for good investment opportunities along the way.

My portfolio was still making a net total loss from January to April. After April, since the market value of my portfolio has risen above my cost of portfolio, my portfolio has seen net total gains. I will continue to monitor my investments and try my best to live out a focused value investing philosophy. I am more interested in longer term returns than short term returns, as short-term performance may not mean anything at all. A good investor is one that can invest at high compounded annual rate of returns over decades.

My unrealised gains has increased sharply since April due to the sharp rally until now. My realised gains from a limited amount of trading (full divestment of Jaya Holdings and partial divestment of CapitaCommercial Trust) and dividends received has also increased from January until now. I am looking at further growing my realised gains not from trading of stocks but from increasing my cost of portfolio by regular reinvestment so as to increase the amount of dividends I will collect from an enlarged cost of portfolio. By reinvesting through the future years, I hope to enlarge my cost of portfolio and allow compounding to continue it's work. Sir Albert Einstein once quoted that one greatest discovery to humanity is the effect of compounding. When compounding works in finance and investment, it is truly amazing how a small capital base given sufficient time by compounding can magnify it's value by many folds.

Discussion points:- Is buy-and-hold a dead end strategy? I may not think so. As long as it is used properly, buy-and-hold approach may even be better than an active trading strategy considering the amount of transaction costs that are bore by an active trading strategy that eats into returns.

Compounding is an amazing mathematical effect. An investor that regularly reinvest will allow compounding to exert it's effect on his investment to increase his original investment many folds over a period of time. The higher the compounded annual rate of returns, the higher will an investment grow in value over time. Of course, getting consistent high compounded annual rate of returns is by no means easy. It requires continuous effort by the investor to invest prudently and wisely to acheive such high compounded annual rate of returns over a long period.

I shall present more discussions on the companies in my portfolio in future posts. I wish all readers the best in your investment journey.

A simple walkthrough on comparing companies in my stocks portfolio (Part 2 of 2)

All companies in my portfolio show steady growth in net income and revenue

Based on my last post, I have provided the net income and revenue trends of companies in my stock portfolio. All the companies show a steady growth in their net income and revenue through a 10 years period except for Parkway Holdings and Tat Hong Holdings which show a lower net income for the most recent year because of individual losses on some exceptional items (see my pevious post). I view these recent losses to their net incomes as non-recurring one-off exceptional losses on items which did not stem from any permanent deteroriation in their business fundamentals. So, it should not affect their future growth in net income.


Recapitulation on the different metrics

Net margin

Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business.

Asset turnover

Asset turnover measures how efficient a company is at generating revenue from each dollar of assets.

Financial leverage

Financial leverage shows how much debt a company has relative to shareholders' equity.

Return on asset (ROA) (%)

Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets.

Return on equity (ROE) (%)

ROE shows how much returns a company can generate for its shareholders' equity.


Method of presentation

I shall present the comparison of companies in my portfolio through using charts and provide a short discussion after each metric I use to make the comparison. As usual, I do not guarantee any completeness or accuracy in my discussion, data and charts. Readers are encouraged to do own individual assessment and form independent opinions as well.

Note:- All following charts show trends in the different metrics of comparison over a 10 years period except for Tat Hong Holdings which shows only an 8 years trend. The 1st and 2nd year data for Tat Hong Holdings are shown as '0' on the charts as it was not available.

Net income comparison

Based on the chart, it shows that all companies have steady growth in their net incomes over last 10 years (ignoring most recent year's decrease due to the 2008 financial crisis or one-off exceptional item losses). The winner is Keppel Corp with the most significant rise in net income trend. This shows Keppel Corp's ability to grow its earnings at accelerated pace compared to the rest.

Revenue comparison

All companies show steady rise in their revenues over last 10 years. This shows consistent ability to increase sales. A company has to keep increasing sales to grow its business. Otherwise, the business may stagnate over time if sales remain flat over a long period. Flat sales or decreasing sales over a long period may suggest there is no more potential for growth in the company. As investors, one has to decide carefully whether is it wise to invest in a company without much potential for growth (suggesting the business is either mature or losing its economic moat facing tougher competition or facing a more difficult operating environment e.g. due to tougher business regulations).

Net margin comparison

All companies show a steady increase in their net margins over last 10 years. Ignoring any exceptional items for any years affecting the net margins, only Tat Hong Holdings and Keppel Corp's net margins show the most stable increase over last 10 years. Net margin measures the profitability of a business (how much of each dollar of revenue a company keeps as earnings). It also shows whether a company is able to maintain a low cost of doing business. It seems Tat Hong Holdings and Keppel Corp are able to achieve a slightly higher net margin (suggesting their businesses are more profitable and they are able to maintain a low cost of doing business??).

Asset turnover comparison

From the chart, it suggests that SembCorp and Tat Hong Holdings are able to maintain a higher asset turnover over the rest. SembCorp leads the rest by having the highest asset turnover. Asset turnover measures how efficient a company is at generating revenue from each dollar of asset. It also simply measures how productive is the asset of a company. Thus, SembCorp seems to own assets that are highly productive for its business.

Financial leverage comparison

Parkway Holdings and Tat Hong Holdings have slightly lower financial leverage than the rest. All companies have financial leverages lower than 3 which is still not much cause for concern. This suggest that these companies do not have excessively high amounts of debts compared to shareholders' equity, and their capital structure is sound. A company has to use debts and equity to fund it's business. However, businesses that can maintain low financial leverage and yet is profitable for a long period is commendable suggesting that such businesses are funding their operations mainly through earnings made (since such businesses have good economics), and they only need to employ little amounts of debts or none at all.

Return on asset (ROA) (%) comparison

All companies show steadily rising return on asset (ROA) over last 10 years (ignoring one-off non-recurring exceptional increase shown by Parkway Holdings possibly due to gains from disposal of assets when setting up Parkway Life REIT). ROA measures how much profits a company generates on each dollar of asset. A steadily rising ROA suggests a company is able to continually acquire and own assets that are more productive and is also able to use the productive assets efficiently to generate more profits.

Return on equity (ROE) (%) comparison

All companies show steadily rising return on equity (ROE) over last 10 years. Most companies have managed to grow their ROE to current level of more than 15% which is generating good returns for their shareholders' equity. However, only ROE for Parkway Holdings is consistently below the rest for most years and under 15% benchmark for acceptable good overall profitability for most types of businesses (ignoring one-off exceptional increase in 2007 due to gains from disposal of it's assets).

Discussion points:- It is difficult if not impossible to find really cream-of-the-crop companies that are excellent all-rounder in many measured metrics. It is even more difficult to find companies that can consistently out-perform over a long period of time.

I believe as long as a company shows a general rising trend in many metrics of measurements over a long period (more than 10 years) and is perceived to continue doing so in many years to come, it will make good sense to invest in such companies with consistent excellent economics in their favour.

Past performance of a company may not guarantee future performance. An investor after selecting a good company to invest in has to continually monitor the company's progress and watch for any permanent deteroriation in business economics in future years. As long as the company continues to perform well in it's business, it will continually generate good returns (compounded annually) for it's shareholders the longer the shareholders stay invested with such excellent businesses.

A simple walkthrough on comparing companies in my stocks portfolio (Part 1 of 2)

Why analysing business fundamentals matter to the bona fide investor?

I had earlier exposed myself to some fundamental analysis during this year from my previous post on looking at return on equity (ROE). I have heard before comments from some investors or should I say market players that it may be futile to look at fundamentals of companies when doing investments. These "market players" some who are experienced with the stocks market adopt a technical view when dealing with the stocks market. To them, making profits is simply about investing at the right time just before a particular stocks is foresee to rise significantly in price. It does not matter whether the underlying business of the company is profitable or not. What matters is that the stock price must rise or fall in a short time period for such market players to make their gains (from going long or short). As such, technical analysis by looking at charts and indicators is paramount to their decision to buy into or sell out of a particular stocks at particular opportunate times when the signal for action is clear.

I am not in a position to comment on the merits or demerits of adopting such a methodology to secure gains from the stocks market. Some investors that use technical analysis protray strongly that this method boasts of excellent consistent returns over a long period of time. How true is it? Only the investors themselves who practise investing by technical analysis know it best. My purpose here is not to challenge the method of technical analysis nor to compare between technical analysis and fundamental analysis. I believe there are different investment philosophies that investors can naturally use according to their own personality. As such, it is one's own free will to choose whichever method, be it fundamental analysis or technical analysis or both together to use it according to own investment style.

For me, I adopt a fundamental approach to stocks investing. In one of Warren Buffet's famous investment quotes, the "stock price eventually follows the business", this shows strongly that the price of a stock does regress towards the intrinsic value of the business underlying the stock. As to the time required for a stock to be fairly valued either from an undervalued or overvalued price, it may take weeks, months or even years. Because the stock market is not efficient, prices of securities do get undervalued or overvalued at different periods of time (e.g. bear market or bull market). An astute investor will try to buy stocks at undervalued prices and sell stocks at overvalued prices to make the largest returns on their investments. However, investing can be made most profitable if an investor views investing as long term riding on excellent economics of selected businesses that really make good consistent returns for their shareholders over a long period of time.

There are already examples of such businesses as Coca Cola and Wal-Mart in Warren Buffet's holdings. An examination of our local context reveals businesses such as Wilmar International that have grown in their intrinsic value through the years into a giant enterprise now and is no longer the once "ikan billis" (small fry) that is not heard of. So, are fundamentals of businesses relevant to investing? The answer is yes. If an investor can invest in such companies that have consistent good business economics in their favour, the value of the company will increase many folds over a period of time as the company gains market share and economic moat. By then, an investor's original investment will increase many folds in value when the business has increased in intrinsic value over time. I examine one such company in my portfolio, SembCorp which has a historic low price of around $0.80 per share. I can only hope in my wildest dream that it's stock price may have a chance of revisiting such lows in future which is almost impossible. This company is worth far more in intrinsic value than $0.80 per share (my estimated intrinsic value is $4.55 per share - see earlier post). So, a patient investor who still holds onto shares of SembCorp bought at such low price years back is already seeing high current earnings yield (about 37%) and future earnings yield as long as SembCorp continues to grow in profitability of their businesses in future years. Such an investor has also secured a high current dividend yield and future dividend yield of around 13% assuming SembCorp provides the same amount of dividends per share in future years.

Thus, by looking at fundamentals and going long with a business that is really worthy, an investor can receive excellent returns on investment especially if the investor has invested at such businesses at low undervalued prices. When the intrinsic value of such businesses continue to grow, the investor's capital investment also grows in value as well. A caution though that holding investment of such long nature focuses solely on the growth of the selected business's intrinsic value and ignores market fluctuations in prices over the years.

Net income and revenue trends of companies in my portfolio

As discussed in my previous post on the metric return on equity (ROE), I shall continue to evaluate a few companies in my portfolio based on metrics such as net income and revenue trends, net margin, asset turnover, financial leverage, return on assets (ROA) and return on equity (ROE). Before I begin my discussion, one should note that these metrics provide only some comparison and evaluation on the profitability of companies. Fundamental analysis is simply a broad topic of investment interest that involves so many ways to evaluate a business. Different investors and analysts may adopt different ways to evaluate a business. Every investor has his own unique ways to evaluate a company and the ways may change too. One should never rely heavily on any particular metric or way to evaluate a company, but should always be as objective as possible and is aware that there is always the possibility of misjudging a company.

For me, the above mentioned metrics provide an overview into the evaluation of companies in my portfolio. I shall present the collected data from the various companies' financial statements (found in their annual reports). I do not guarantee the completeness or accuracy of these collected data. Readers are advised to practise caution when reading and using the data.

I will only provide the trends I observed for net income and revenue in these companies over a period of 8 to 10 years. Net income and revenue should grow together consistently for a good business. I personally places more emphasis on a business's ability to generate growth in operating cashflows and free cashflows more than looking at net income and revenue growth because cashflow is more important determinant of a company's ability to generate real cash. Nevertheless, net income and revenue growth are also important as they reveal whether a business is making more sales and earnings through the years.

There is steady net income growth and revenue growth over the years.

There is steady net income growth over the years except the most recent year when there is an impairment loss on trades receivables for Parkway Holdings due to a default on payment for hospital services. As this is a one-off problem, it will not affect future net income of Parkway Holdings. There is steady growth in revenue over the years.

There is steady growth in revenue over the years. There is steady growth in net income over the years expect for most recent year mainly due to foreign transaction losses. As this is a one-off problem due to change in exchange rates of foreign currencies, it may not affect future net incomes.

There is steady growth in net income and revenue over the years.

Discussion points:- It is important to evaluate business fundamentals of a company when investing in the stock of a company. This ensures an investor can potentially invest in good businesses that increase their intrinsic values over time.

All companies evaluated here shows a steady growth in both net income and revenue over the years. This suggests that their businesses are generally stable and consistently profitable over a period of time. Examining trend over a number of years is important as it checks for consistency in the economics of a business.

I will provide comparison on the net margin, asset turnover, financial leverage, return on asset and return on equity for these companies in a later post.

A look at return on equity (ROE)

After picking up some learning on how to value stocks (see earlier posts), I came to the attention of a frequently raised metric for measuring a company's profitability in the various investment literature I have read. This metric is termed return on equity (ROE in short).

Recap on valuation methodologies

Before I embarked on a discusssion on the usefulness of this ROE metric and its possible limitation, I wish to summarise my learning so far on valuing a company to know when it is wise to invest for the highest possible rate of returns. I have discussed the use of earnings yield to estimate how much yield one is getting currently by paying the current price for a stock and also estimating future yield on one's investment at current share price. Earnings yield is the reverse of P/E ratio, using earnings per share (EPS) divided by current share price and calculated as a %. I think this is a better way to determine the current yield one will be getting by investing at current share price compared to using P/E ratio. If EPS is high compared to current share price, one will ensure a high current yield when investing in a company. If the future yield can be projected with high probability based on past consistent growth in EPS of a company, one may be able to look at the future yield on one's current investment. Please refer to my earlier post "Waiting for the perfect pitch - Looking at yield on one's investment" for more details on estimating yield on investment.


The limitation of using P/E ratio is that it is difficult to determine which P/E ratio means undervalued or overvalued for a company (P/E ratio lower than 20? How about P/E ratio lower than 10?). There are many factors to consider when using P/E ratio to value a company, so it is not so easy to estimate a company's worth using P/E ratio alone. Since it is not my intention to discuss P/E ratio in details here, I will leave this for future post.
 
Another way of valuing a company is using a discounted cashflow (DCF) method. In using this method, one is assuming that continued ability to generate free cashflows by a company is critical for its continued survival and growth. However, as in using other valuation methods like earnings yield and P/E ratio as discussed earlier, all methods carry with them their individual limitations. DCF valuation method does not work for a company with inconsistent or negative free cashflows for most of its operating history. Also, it is not easy to estimate future growth in cashflows and the appropriate discount rate for the future cashflows to its present values. One's estimation is as much a guess compared to another's. So, to account for this uncertainty in estimating the intrinsic value per share for a company, an investor has to practise a conservative approach to invest at a margin below the estimated intrinsic value of a company called the margin of safety. Please refer to my earlier posts on "Determining intrinsic value per share of a stock" for details on using DCF to value a company.

Return on equity (ROE)

Return on equity (ROE) is a popular metric embraced by many investors and analysts for measuring the profitability of a company. How useful is it? ROE consists of three components.

The first component (Net income / Revenue) is also called 'Net Margin'. This first component can also be termed simply 'Profitability' of a company.

Net margin shows how much of each dollar of revenue a company keeps as earnings after paying all costs of doing business. A net margin (expressed in %) of 30% shows that for every dollar of revenue made, $0.30 is left over as earnings after paying off $0.70 for all costs of doing business. So, the higher the net margin (in %) the more profitable is a business.

The second component (Revenue / Assets) is also called 'Asset turnover'. This second component can also be termed simply 'Productivity' of a company.

Asset turnover measures how efficient a company is at generating revenue from each dollar of assets. A high asset turnover means the company is more productive at generating revenue from its excellent assets.

These first two components can be combined to provide the metric 'Return on assets' (ROA) as follows:-

Return on assets (%) = Net margin (%) X Asset turnover

Return on assets (ROA) shows the amount of profits a company is able to generate per dollar of assets. Companies having high ROAs are good at producing profits from their assets.

The third and last component (Assets / Shareholders' equity) is also called 'Financial leverage'. Another common term used to describe this same component is called 'Capital structure' of a company.

Financial leverage shows how much debt a company has relative to shareholders' equity. A high financial leverage ratio (e.g. significantly more than 2) may mean a company is taking on excessive debts which is risky especially if the business of the company is a cyclical or volatile one.

Usefulness of ROE

When the three components discussed above are combined together, they form the metric return on equity (ROE). The usefulness of ROE is that it shows how much returns a company can generate for its shareholders' equity (remaining interest spread among shareholders in the assets of a company after all liabilities are paid). This is shown in the reduced equation:-

ROE = Net income / Shareholders' equity

A company that shows consistently high ROE (15% or higher) over a long period of many years suggests that it is generating good returns for its shareholders. This is testimony to the company's continued profitability in its business model, economic moat and management effectiveness.

Limitation of ROE

ROE can be artificially inflated by the third component 'Financial leverage'. If the company is taking on large amounts of debts in its capital structure and having low equity base, the high financial leverage computed into the calculation of ROE can make the ROE looks too high to be true. So, an investor has to be careful when dealing with companies with high financial leverage. Investigate carefully why a company is taking on excessive amount of debts in its business. Is there justification for doing so? By being careful, it will possibly save a potential investor of unwelcomed surprises in future when a company shows up as financially unhealthy laden by excessive debts to be cleared.

Often, it is better to approach the evaluation of fundamentals of companies from a pessimistic viewpoint to dig up all possible negatives before considering the positives of the fundamentals of a company. If a company is truely an excellent one, it will stand the test of uncovering negatives about it.

Discussion points:- Return on equity (ROE) is a popular yet important metric for measuring overall profitability of a business. A consistently high ROE of 15% or more suggests that a company may have good business model, economic moat and management effectiveness.  

ROE is not a magical sure-win metric. It is important to take note of the third component in this metric (financial leverage) when using ROE. A company that has high ROE but also high financial leverage may warrant further investigation to find out why a company is taking on execssive debts before putting a myopic confirmation to its profitability based on just looking at ROE alone.

Sound investing does not hinge on using only one metric (e.g. ROE) alone to judge a company's worthiness as an investment candidate. As such, ROE can be broken down into its three components to uncover further stories about a company (e..g its net margin, asset turnover and financial leverage).

Also, there are many other ways apart from using ROE to evaluate a company's fundamentals. Nevertheless, ROE continues to be a very useful metric for evaluating a company.

More on the practice of using ROE and its components in evaluating companies in my stocks portfolio in later posts.

Determining intrinsic value of some stocks in my portfolio - Do not overpay for stocks!

The Singapore stock market has rallied over the past few months on the news of gradual recovery in the global economy. All stocks in my portfolio have seen gains, some more than others. Though I am satisfied by the gains in share prices of stocks in my portfolio, I still do not feel comfortable with a few stocks in my portfolio because I found that I am holding them at average share price higher than their estimated intrinsic values. Thus, I will seek to discuss on the mistakes I may have made in holding a few stocks in my portfolio at higher than their intrinsic value per share. Intrinsic value is very important to me as a focused value investor as it provides a guide to me as to whether I am overpaying for a particular stocks. By overpaying for a particular stocks (even if the stocks is supported by good underlying business), it will diminish long term returns and does not provide any margin of safety in case the business does not fulfill the intrinsic value as judged by the investor. As such, I am not comfortable with overpaying for any stocks.

Before I seek to estimate the intrinsic value per share, I will first present some financial statements for a few companies I have invested in. The statements include net cash from operations, capital expenditure and free cashflow. Then, I will provide a simple analysis on these companies based on their financial statements. Also, I will provide a sample on how I estimated the intrinsic value per share for one of the company.

Please bear in mind that I am not a qualified accountant nor analyst. I do not guarantee the accuracy of the financial statements presented here. Also, the opinions expressed here are my own personal judgments. So, please take my sharing with a pinch of salt. The purpose of my discussion is to provide a training and discussion ground for the exercise of evaluating a company's cashflows and determining their intrinsic value per share based on their present value of projected cashflows. All figures presented are just estimates and may not be accurate.

Recap:- Free cashflow = Net cash from operations - Capital expenditure

Keppel Corp

Keppel Corp's net cash from operations have been fairly stable for 10 years. It has grown steadily over the years to the current level of around $ 2 billion. This indicates consistency and stability in generating cash from its operations.

The capital expenditure has remained fairly constant over the years and is not excessive. This results in positive free cashflows for most of the years. The free cashflows has also risen slightly over the recent years.

Thus, I peg a consistent growth of around 2% compounded annual growth (CAGR) for its future cashflows as I think the company is mature and its future cashflows may not outperform its current cashflows significantly which is already steep. As the company is able to generate consistent cash from operations with positive cashflows, I see this as a stable company going forward. So, my discount rate used in the calculation of DCF is 10%, a fairly conservative discount rate to account for my opportunity cost in investing in this company and also my risk premium (see earlier post for details on DCF model).

I have created an excel spreadsheet incorporating the calculations for DCF. The estimated intrinsic value per share for Keppel Corp based on my spreadsheet after taking into account the 2% CAGR for future cashflows, 10% discount rate on future cashflows to their present value, total number of shares, and a long term rate of growth on its cashflows of 3% beyond the 10 years is $13.04 per share.

As this is just an estimate on what each share of Keppel Corp is worth, this intrinsic value may not be accurate. To account for any misjudgments, it is always wise for the investor to invest at below the estimated intrinsic value. Investing at below the estimated intrinsic value per share allows a margin of safety to account for possible errors in estimating the intrinsic value. The lower the share price an investor buys its shares below this estimated intrinsic value, the better safety margin to account for any errors in misjudging the worth of a company's shares.

My current average holding price for Keppel Corp's shares is $4.05 per share (see earlier post on my stocks portfolio). Thus, my margin of safety is around 221% which is very significant. Even if I overestimated the intrinsic value per share for Keppel Corp, I should be well buffered against my misjudgment since my holding price for Keppel Corp's shares is very low.

Sample of the Excel spreadsheet I use for estimating intrinsic value per share

SembCorp

Fairly consistent net cash from operations with only two years showing negative values. Fairly consistent capital expenditure over 10 years. Most years with positive free cashflows.

I peg a CAGR of 5% for its future cashflows and a 10% discount rate on future cashflows to present value on the consistency of its cashflows generating ability.

The estimated intrinsic value per share I arrive at is $4.55 per share.

My current average holding price is $3.35 per share. This provides a margin of safety of 35.8%.

Tat Hong Holdings

Its net cash from operations is a bit inconsistent with some years having a significantly lower net cash from operations. Its free cashflows is also inconsistent with negative free cashflows for some years.

I peg a 5% CAGR for its future cashflows since this company is still growing and expanding its operations in China. However, I peg a slightly higher discount rate of 12% on its future cashflows to present value because of its inconsistent cashflows to account for a higher risk premium that its cashflows may not materialise in future.

The estimated intrinsic value per share is $0.65. My average holding price is $0.658 per share. Thus, I do not have any safety margin for this stocks.

Parkway Holdings

Net cash from operations has been growing steadily through the years. Capital expenditure has also grown throught the years. Free cashflows has also grown steadily through the years expect for negative free cashflows in latest year. The high capital expenditure in the latest year could be due to its aggressive expansion overseas resulting in a negative free cashflows.

I peg a 5% CAGR for its future cashflows on the consistency of its ability to generate free cashflows based on the defensive nature of its healthcare business. As such, my discount rate on future cashflows to present value is also lesser at 8%.

The estimated intrinsic value per share is $1.29. My average holding price is $1.758 per share. I have invested at a higher premium than its estimated intrinsic value (fatal mistake for a value investor). This would have been risky saved for the fact that the nature of its healthcare business is defensive and provides stable stream of cashflows. Thus, I am still willing to hold my shares to allow the intrinsic value of this company to grow beyond my holding price per share.

Discussion points:- The exercise of estimating intrinsic value per share for a company is both science and art. The estimated intrinsic value is by no means an absolute since it is difficult to forecast the future cashflows of a company accurately.

Valuation of a company (estimating its intrinsic value per share) is only part of the game. An investor has to analyse more parameters apart from just cashflows from a business to determine whether a business is worth investing in.

A value investor always seeks to invest at a margin of safety below the estimated intrinsic value per share. This is to account for any misjudgments in the intrinsic value per share of a company.

An investor may still invest at a slightly higher premium to the estimated intrinsic value per share of a company if he is convinced after sound analysis that the company is able to grow its intrinsic value in future beyond the investor's current holding share price.

More discussions on my experience with analysing the fundamentals of the companies in my portfolio in later posts.

Determining intrinsic value per share of a stocks (Part 2 of 2) - A company is worth the present value of all its future cashflows?

I shall now follow through the discussion on how to calculate the present value of a company's future free cashflows. Before I continue my discussion, please be cautioned to take my sharing with a pinch of salt. This is because I am by no means a qualified accountant or analyst. I am just an average retail investor doing my own research into investing methodologies and principles from reading investment literature and attending investment seminars. However, I believe in constant learning and correcting my mistakes so as to become a better investor with time. One has to start off somewhere to fall and pick oneself up and fall again and repeat the whole process of falling and picking oneself up constantly in order to grow no matter in which areas of life, not just in investing.

An old traditional method - Looking at present value of future cashflows to determine investment value

Early economists more than 60 years ago like Irving Fisher and John Burr Williams proposed that the value of a stock is equal to the present value of its future cashflows. In my earlier post, we have seen how free cashflows are important to a company as it is the freed up cash that can be taken out of a company yearly without harming its business. Portions of free cashflows can be reinvested into a business, paid out to shareholders as dividends or be used in share buy backs to increase the % ownership of each shareholder.

There is a need to calculate the present value of future free cashflows a company is projected to generate. This is because the future cashflows investors would expect to receive is worth less than the current free cashflows. Two reasons abound regarding why future cashflows is worth lesser than current cashflows. Firstly, money we receive today can be invested immediately to start generating returns, but we cannot invest future money until we receive them. This is also called the opportunity cost of receiving money in future compared to receiving money today. Money at hand always has better immediate investment value than future money as it can be put into investing straight away to start compounding returns. Secondly, there is a risk an investor may not receive a company's future projected cashflows, and there is a need to compensate this risk taken, also called the risk premium.

Risk premium also depends on the nature of the business, whether its free cashflows is consistently stable or unstable. A company where its free cashflows keeps fluctuating through the years with no stability makes it difficult to predict its future cashflows with certainty, thus such company carries a higher risk premium.

Due to opportunity cost of receiving money in future compared to now and also risk premium, there is a need to discount the future cashflows a company is projected to generate by a discount. The higher the opportunity cost and risk premium an investor has to absorb, the higher will be the discount on a company's future cashflows to calculate the present value of the future projected cashflows.

As such, this simple idea of discounting a company's projected future cashflows to a present value is called the discounted cashflow (DCF) model for valuing a company's intrinsic value.

No investing methodology is perfect and an investor has to understand the possible limitations of every methodology. DCF assumes that a company's intrinsic value depends solely on the present value of future cashflows it is projected to generate. So, this method places importance on valuing a company based on free cashflows. If an investor is convinced a company's value is tied strongly to the amount of free cashflows it can generate for a period of time and he is willing to only pay for a company's free cashflows, then this method will make absolute sense for him. If an investor is not convinced by DCF model, it maybe better for him to adopt other ways of valuing a company (e.g. looking at P/E ratio).

Mathematical calculations behind Discounted Cashflow (DCF) model

It is not my wish to bother with complex calculations when doing investment. After reading some literature on Warren Buffett's investing wisdom, I remember one quote from this master investor which mentioned that investing is not a simple exercise, neither is it meant to be a complex exercise requiring intense mathematical calculations that it is not attainable by many without a relevant degree of certification. So, a high IQ investor with ability to crunch complex data and financial figures may not necessarily make a better investor than one with some basic financial and investing knowledge. As more variables and factors are considered in assessing an investment, it may not necessarily make an investment sound as an investor has a chance of misjuding each variable being considered. So, the more variables being considered in assessing an investment means more chances of misjuding the investment.

Thus, I will try to keep the discussion of the DCF model simple. My hope is not to provide a rigourous discusssion over this model but rather to bring out only simple appreciation on the required calculations and later to discuss this model's usefulness and limitations based on the context of its required calculations.

CFn = Free cashflow generated for nth year (e.g. CF1 means free cashflow generated for first year),

r = discount rate (depends on opportunity cost and risk premium)

Step 1: We have to forecast the free cashflow (FCF) a company can generate for next 10 years. For simplicity (since I am not an analyst trying to be as accurate as possible; anyway I don't think analysts can be perfectly accurate or else they would have make millions themselves in forecasting a company's future prospects so perfectly if they are really able to do so), I forecast a stable company should grow its free cashflows over 10 years at a pre-determined fixed compounded annual growth rate (CAGR). The compounded annual growth rate to use is rather subjective depending on individual investor. I use the same compounded annual growth rate based on a company's past cashflows.

For calculations of future cashflows for 10 years at my pre-determined annual growth rate, I use the formula Future cashflow = Present cashflow X (1+ r/100)^n, where r is the compounded annual growth rate and n is the number of years.

E.g. Company A's current cashflow is $100. It can grow at 10% compounded annual growth rate. At first year, company A can generate cashflow CF1 of $100 X (1+10/100)^1 = $110. At second year, it can generate cashflow CF2 of $100 X (1+10/100)^2 = $121. The calculation goes on until the 10th year.

Step 2: After forecasting all the future cashflows, we have to discount each cashflow by a discount rate to account for the opportunity cost and risk premium. Again, determining an appropriate discount rate is subjective. An investor can consider the yield he will receive on an alternative risk free investment (e.g. government bonds) had he not considered this current investment which is being assessed. Let's assume Singapore government bonds over a 10 years maturity period provide yields around 3 to 6% annually. So, an investor can have a discount rate of at least 3% over here. An investor can consider a higher discount rate than 3% (say 12%) if he perceived the company is risky and he should be compensated at higher discount rate on the future cashflows to calculate the present value of these future cashflows. So, a more conservative investor considers a higher discount rate when discounting future cashflows to their present value.

Step 3: Now, we have worked out the sum of all discounted cashflows for 10 years period (based on steps 1 and 2 plugging in the various values like current cashflow of a company, its cashflow compounded annual growth rate and its discount rate). We still need to determine discounted perpetuity value. Discounted perpetuity value is necessary to account for present value of a company's projected cashflows beyond 10 years. It is not feasible to compute all discounted future cashflows to infinity number of years, so a discounted perpetuity value estimates the present value of future cashflows far beyond 10 years.

(I will not present the calculations for discounted perpetuity value since my intention is not to provide a rigourous discussion on the mathematical calculations behind DCF model)

Step 4: Calculate total discounted cashflows (DCF) by adding 10 discounted cashflows for 10 years to the discounted perpetuity value. (Refer to DCF formula above)

Step 5: Calculate intrinsic value per share by dividing total discounted cashflows (DCF) by total number of shares outstanding for a company.

Discussion points on DCF model for determining intrinsic value per share of a stocks:-

1. There are at least two important variables affecting the calculations of discounted cashflows (the forecasting of future cashflows and the discount rate applied to discount the future cashflows to their present values).

2. It is by no means easy to forecast future cashflows. The compounded annual growth rate (CAGR) to use for determining future cashflows is subjective. An investor who is optimistic about a company's future cashflows can use a high CAGR to determine future stream of cashflows. Similarly, a conservative investor can use a lower CAGR. It depends on the investor's assessment of the company's future abililty to generate cashflows.

3. The discount rate an investor chooses can also be subjective. A conservative investor may use a high discount rate to discount the future cashflows to their present value. This is to account for the opportunity cost and risk premium he thinks he has to absorb when investing in the company. The discount rate may go as high as 15% to 20% up to the comfort level of an investor.

Conclusion:- DCF model is not a sure-win magic formula for determining intrinsic value per share of a stocks.

Different investors using the same DCF  model may still arrive at different intrinsic value per share for the same stocks depending on the CAGR they use to determine the future cashflows and the discount rate they use to discount future cashflows to their present value.

As such, DCF model is just one of many tools available for determining intrinsic value per share of company stocks. Valuation by DCF model may not be totally exact science, but it is partly an art since there is no absolute perfect forecast of future cashflows and no one perfect discount rate to be taken in the calculations of discounted cashflows. 

Thus, as with any other valuation tools, DCF model serves only as a guide and is not an absolute way to determine intrinsic value per share. No one can really peg a true intrinsic value to a company. Intrinsic value does change with time also. Therefore, an investor should always seeks to invest at a margin of safety below calculated intrinsic value per share to account for any misjudgment of the intrinsic value of a company. 

More discussions on using DCF model to determine intrinsic value per share for stocks in my portfolio, and I will also seek to discuss some mistakes I have commited by investing at higher than intrinsic value per share for some stocks in my portfolio in later post.

Determining intrinsic value per share of a stocks (Part 1 of 2) - Why free cashflows matters to a business and shareholders?

Why the need to determine intrinsic value per share of a company?

Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.

Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.

Free cashflows is the lifeline of a business

Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of  future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).

Free cashflows = Net cash from operating activities - Capital expenditure 

To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.

Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.

Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.

Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.

More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.

Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure

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

The 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.

My stocks portfolio (as at 30 Sep 2009) - Result of living out a focused value investment philosophy.

After I had divested out of Jaya Holdings (see earlier post) around August this year, I bought into shares of SembCorp with the small profit on divestment. I also increased my other holdings with the small profits on divestment. My reasons for divesting Jaya Holdings are mentioned in my earlier post. I bought into shares of SembCorp as I find that it is a large cap blue chip stocks dealing with multi-industry businesses. It owns the subsidary company SembMarine which is the world's second largest oil rig builder. I decided that investing in an already established large conglomerate like SembCorp is afterall better than investing in a smaller business like Jaya Holdings. Given a large cap and a small cap businesses are both comparable in future long term prospects, it is the larger one having far longer consistent track record that may provide more stability in long term investment. Afterall, the larger business has already established itself with a longer proven track record providing more credibility to continue its operations based on good branding and business characteristics.

My stocks portfolio

Learning to live out a focused value investment philosophy

As I have mentioned in my earlier posts, I started entering the stocks market during late June 2008. My two earliest stocks that were bought included CapitaCommercial Trust and Parkway Holdings. As I was still reading up books and researching on stocks investment during that period, I did not firm up an investment philosophy unique to my personality. My earlier buying trades into CapitaCommercial Trust and Parkway Holdings were based on gut feelings with some emotions involved. It was later that I aligned my learning from these practical experiences with my investment reading and research that I firmed up my own investment philosophy, which is that of a focused value investing philosophy. An investment philosophy is necessary for an investor. It is his own guiding principles on making every investing decisions (e.g. what stocks to buy, when to buy and when to sell). An investor without his own living investment philosophy will be confused and clouded by emotions whenever executing his investing decisions. This is because his thinking keeps changing based on emotions affecting his every decisions. He always questions what he is doing and is unsure if a decision is rightly made since there is no inherent investment philosophy to draw upon as a guide.

After I have firmed up my focused value investing philosophy, every decision and thought becomes clear always supported by the investment philosophy. Making a decision is no longer difficult since it is backed by the investment philosophy. Owning only a few stocks in concentrated positions; buying stocks only at a margin of safety below its intrinsic value; selling stocks only when it is grossly overvalued or underlying business fundamentals have deteroriated permanently or there is a better alternative stocks worth investing; always look at buying stocks as part-ownership in a business, so it is vital to constantly analyse and monitor underlying business of a stocks. These are the guiding principles of my investment philosophy and once an investor has lived out his own investment philosophy, making an investment decision is as easy as breathing since he carries out every decisions naturally. It becomes his own natural investment style.

Therefore, my current portfolio is the result of slightly more than one year of practical learning to live out my investment philosophy, that of a focused value investment philosophy. The more I practise my investment philosophy in thinking and making decisions, the more it becomes a natural part of me. I am still learning and will be always learning to live out a focused value investment philosophy.

Weightage of individual stocks in my portfolio

There is a conventional portfolio management style which says an investor must seek to rebalance the weightage of the stocks in his portfolio. As such, he should sell some shares that have appreciated too much in value and buy other shares so as to keep the weightage of individual stocks in his portfolio constant. E.g. an investor's portfolio is made up of 30% stocks A, 30% stocks B and 40% stocks C. If the price of stocks A has run up such that the portfolio is made up of now 50% stocks A, 20% stocks B and 30% stocks C, by conventional portfolio rebalancing management, the investor must sell some shares of stocks A and buy more shares of stocks B and C to rebalance the % of each stocks back to the ratio 30%: 30%: 40%. This is to reduce the risk of any particular stocks dominating the portfolio and rebalances the weightage of individual stocks according to a pre-determined ideal fixed ratio.

However, based on focused value investing philosophy, the investor does not care about % weightage of individual stocks in his portfolio. He assigns more funds constantly into the stocks he thinks is more promising than others and/or is more attractively priced to acquire more of its shares. As such, there is no fixed % weightage for individual stocks in his portfolio and it keeps changing according to the prospects of individual stocks. As such, I do not believe in rebalancing as an approach to portfolio management. Ride the winners and weed out the losers constantly.

Transaction costs drag down investment returns

The total transaction costs of $1425.29 incurred for all my trades translates to a decrease in 1.52% from my total returns resulting in net 40.5% returns since I started out in late June 2008. I was amazed by such a hefty sum in transaction costs incurred considering that I do not practise active trading of stocks. I really wonder how an active trader trading frequently in many small positions can achieve good returns after deducting the hefty transaction costs even through low cost online brokerage trading?

As such, I am now more conscious of transaction costs. Afterall, a focused value investor waits for the perfect pitch to buy and sell shares only when the best opportunity strikes. Inactivity really matters to prevent having a high turnover in portfolio magnifying transaction costs. Execute trades only when necessary. Otherwise it is better to do nothing.

Further discussions will be provided on my portfolio in subsequent posts.

Discussion points:- It is vital to have a unique investment philosophy aligned to one's personality. When one lives out his investment philosophy, he is no longer basing his every investment decisions on changing emotions. Every investor is unique and may not share similar investment philosophy.

Rebalancing is not an effective way to manage portfolio. Instead, have the courage to invest heavily in the most promising stocks in one's portfolio. Ride the winners and weed out the losers constantly in one's portfolio.

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