One big advantage small individual investors have over bigger funds

It is clear that managed funds may have some advantages over us smaller guys, such as the ability to meet management. However, one huge disadvantage they face over us are liquidity/portfolio size constraints. Managed funds managing $1 billion will have big difficulties moving a substantial portion of their money into smaller companies. This provides us with a huge structural advantage. In a sense, buying into large cap stocks is throwing away this advantage we have. The reason why smaller caps may be beneficial is because they tend to be under-researched companies and not invested in by bigger funds. For these reasons, there is a greater chance of securities being mis-priced. 

Yes, smaller companies tend to be riskier, but not all. A company that comes to mind is Nick Scali. I'm not saying to go out and buy it, but it's an example of a wonderful business that huge funds will have trouble getting their hands on. I hope this may make you think a little differently or broaden your scope in terms of the investment landscape of which you have at your disposal.

Sirtex Medical (ASX: SRX)

Sirtex is a company that looks interesting. From my two days of reading, here's what i've gathered. Essentially, the company treats inoperable liver cancer. However, the treatment is only used as a last resort at the moment, For this reason, among others, the company only caters for roughly 1% of the addressable market. The interesting thing however, is that the company has engaged in a massive trial study to test it's efficacy and prove the treatment is indeed effective. The study, called SIRFLOX, is due to report its results in early-mid 2015. If the results are positive, the treatment will move form being a last resort to a first (along the lines of Chemo and radiology). This could  mean big business for the company. The interesting thing is though, who out of everyone would know the likely results? The CEO for one. He has gone and tripled production facilities in many parts of the world to meet "expected demand" because he believes the results are positive. My question is, why the hell would he be building excess capacity at the moment, when the results are not out yet? (The head office is actually very close to where i live. I should just pay Mr Wong a visit. Ha, i wish!)

The stock is definitely not cheap whether you're looking at the in terms of the current P/E or even the forward P/E. If you buy in now, you better be aware that the stock could plummet if the results come out negative (which may become a potential opportunity again, but read on to find out why.) However, the CEO has stated that even if the results come out negative, current growth is sustainable. It could be a possible long-term play if some characteristics change. Some  key fundamental metrics such as margins and ROE and extremely strong. It's also debt-free and has only raised a minimal amount of additional of capital in the past 10 years.On top of this it's generating quite a pleasing result on incremental capital. So it's definitely ticking some boxes. One thing to note is that the FCF's are not very good at all (but is somewhat justified given the growth prospects of the company.)

Hunter Hall, an investment company, has stated the company has the potential to be a $100 stock however it would need to address 10% of the market. This may seem like a dream, but if the results are positive, it could become reality very soon. Roger Montgomery is also looking to get on board. I'd definitely keep a close eye on this one.

VSC half yearly accounts

First things first. In the last post I talked about predominantly being a value investor but also a growth investor if necessary. I'd like to point out that i believe, at times, that it's not always clear-cut in distinguishing  between a value stock and a growth stock. I haven't looked into this sort of literature in depth but drawing a line between the two isn't necessarily a fluid task. I mean, if a stock has a P/E of 13 it may be considered a value stock, but, if it's 14, is it now classified as a growth? I'm not sure where the distinction lies.

Taking a different view point, Buffett has argued (i think it was in his 1992 annual letter to shareholders but i may be wrong on the date) that growth and value investing aren't separate concepts. His basic premise is that when you forecast future inflows using whichever method you use, you articulate growth rates in those forecasts. Therefore, as Buffett puts it, value investing and growth investing are "joined at the hip". Buffett's business partner, Charlie Munger, has also made the statement that all investing is value investing, i.e. paying less for something than what you perceive it to be worth. The point of this was to suggest that i didn't want to necessarily label myself as one type of investing as it can be argued that they may be the more or less similar depending on the way you view the situation.

Now, onto the reason why i wanted to make a post. VSC came out with their half yearly reports and to be blunt, I'm not too happy. Revenue generation was weak, and the large inclinations in the bottom line came from cost cutting and one-off boosts such as tax offsets which aren't a core part of the business and isn't recurring. For these reasons, adjustments need to be made. Looking at it this way, the growth was quite poor. I still believe the future for the company is promising.  The fundamentals are still quite strong, and, the company has had to deal with tougher problems than this in the past and have come out quite clean. For example, problems with fraudulent management to the Pan Pharmaceutical debacle were much greater problems. Some of these issues date back to 2000, but, it's still relevant in pointing out that the company have been through worse and have pulled through. So, i believe it's too early to start drawing conclusions just yet.

In other news, I'm making a purchase of a new stock this week but will still maintain a surplus of cash  in order to capitalise on opportunities as they arise. 

My investing checklist (to be continued)

When I invest my own money there are some rules I tend to follow. While I am flexible in some aspects, not all factors meet this flexibility criteria. My current aim is not to only follow one type of investing. Rather, learn many and be able to adapt to a given situation. For example, I'm predominantly a value investor, and if a value stock presents itself and I do all the necessary research and it turns out to be an attractive investment, then I'll go for it. However, if a growth stock presents itself with attractive characteristics then I'll also go for it. I intend to keep the descriptions light.

1. Within the circle of competence

A circle of competence is essentially the business in which you can understand well. You should be able to understand what the company does that you’ve put your funds in. This goes much further than just describing what products or services it sells.  

 2.  Businesses with strong competitive advantages

Businesses which can deter entry and retain the ability to earn abnormal profits are ideal. If you can raise prices and not lose customers, then you’ve got a very good business. Examples include, Coca Cola, Wrigley’s chewing gum, Gillette and WD-40 (yes, that thing!)

 3. Solid business with strong fundamentals and a promising future

The past isn’t always the best predictor of the future. If a company has had magnificent fundamentals in the past, the future is what matters. So, focusing on that is what really matters. It could be the case where it continues and even improves like it has with REA, but it might not. So undertaking strong analysis is essential.

4. Low P/E coupled with high returns on equity

A low P/E may be a sign of a stock undervaluation. Barring the normal P/E discussions, a low P/E can act as a risk management tool if it’s the right company. This is because a low P/E signifies that the market isn't expecting much from the company, so if it does have a bad earnings report one season, the capital losses can be reduced. This may also work on the upside. If the low P/E company produces a strong report then the upside could be endless. Contrastingly, if the hottest high-flying growth stock produces a bad report then its price can be slogged. (But i try and be careful and not fall into value traps, especially in trying to identify if there's financial engineering present.)

 A company that is trading at a low P/E that is also generating high returns on shareholder funds is no joke. This can be a powerful combination, and it is one of the reasons that hedge fund manager Joel Greenblatt was able to return 50% p.a. for 10 years (although he specialized in spin-offs and the like.)

5. Margin of safety

What is a value investing check-list without a margin of safety? Typically, the value investors most important risk mitigation tool.

This list is to be continued and i do understand that this list may seem a bit unrealistic and more suited during bear markets.


Some other philosophies  that I tend to follow (but not limited to) in no particular order are:

• ·          Understanding that the market, at times, can be very wrong and market inefficiencies can arise leading to a stock trading at a discrepancy to firm value. Further, that the market will at some point will realise its mistake and re rate the stock.

• ·          Don’t try to predict market direction

• ·          A strong balance sheet        

• ·          Don’t be afraid to hold cash

• ·          Don’t over diversify

• ·           Don’t try and trade frequently

• ·          Exercise patience and due diligence

• ·            Don’t follow the crowd mentality and understanding that the best investing ideas come from independent thinking

• ·           Invest with conviction

• ·          Try not to place too much emphasis on macroeconomic factors such as interest rates especially when it comes to predicting them.

• ·          Try and invest in stocks that have a lack of analyst coverage 

• ·          Strong cash flow generation

• ·             Low P/CF, P/B, P/S (depending on the business)

• ·            There’s not always a risk-return trade-off

• ·           Try and invest in companies where you are able to have a holding period of forever or until certain circumstances change

• ·           Be flexible in approach as an opportunity may present itself anywhere and in any form

• ·          And finally, be fearful when others are greedy and be greedy when others are fearful

My reviews so far

The reviews I were meant to be doing have been put on hold as I've been bed ridden with the flu. The only company i managed to have a look at was G8 Education (ASX:GEM) because i own stock in the company. Their acquisitive growth is strong, with attractive multiples (about 4x EBIT). They also are realising cost synergies, for example, they are keeping employee costs as a % of revenue relatively stable. The highly fragmented child-care services industry provides G8 with much more opportunity. On top of this, they only own about 5% of the market with Goodstart the leader at about 12%. Affinity, is negligible (at the moment accounting for about 1%). I think I'll purchase more of this stock but I'm going to wait for it to fall in price before i do that. Albeit, the debt/equity ratio is getting a bit too much for me to handle! If it rises much more i may exit.

I believe the market as a whole may have a pull-back sometime soon (no idea when). This is because i believe investors are chasing yields as they shift money from cash to securities. This is a dangerous act if there is no justification for doing so. If this continues in the wrong companies, mushrooming prices which aren't backed by strong profits can be detrimental to those who went in at the wrong time and with the wrong mind frame. I.e. short-term focus.

The market being fairly priced/overvalued may also be apparent when looking at Berkshire Hathaway's most recent annual report which shows that the Oracle of Omaha is holding more cash.

Reporting season is among us!

A small reminder that Vita's report comes out soon (i believe it's around the 18th of August). I'm looking for strong EPS growth among many other things. In particular, anything above 20% in EPS/CF growth would be nice and anything below 10%, well, let's just say I'm going to be a bit worried. However, there are other aspects I'm going to be looking at. The recent price hikes are nice, but I'd prefer that prices fell. Let's see what happens after the report comes out. I'm expecting stronger revenues from the Singapore division and weaker revenues from Thailand. I believe margins may improve depending on how the other divisions perform and the relative performance of Singapore (as Singapore is a high margin division).

Other companies I'll have a close look at are: Seek, Carsales, Nick Scali, Real Estate.com.au, Sirtex, G8 Education, The Reject Shop and Coca Cola Amatil. 

A short check list composed by an investment analyst at a fundamentally driven hedge fund

Here's a check list i just found on the internet. It's quite comprehensive and i'd like to borrow the headings and summarise them myself. The  check-list comes from Oliver Mihaljevic.

 A Huge Sustainable Competitive Advantage—A Franchise

In theory, when a business operates profitability it attracts competition. This is in the nature of capitalism. When the competition enters, sales get spread over more shops and so profitability declines. Profitability may also decline because the increased competition has led to increased price competition, among other things. When this occurs, the industry profitability will decline to negative economic profits and then companies will begin shutting down. However, a business with a sustainable competitive advantage or economic moat will allow the business to keep competition away. This may also allow for a franchise type of business (also known as franchise value or economic value).

Within the value investing framework, franchise doesn't mean a shop like Subway, franchise is the name given to a business that can earn above normal profits for extended periods of time (i.e. may not be mean reverting if you believe in that). This can be done by charging a higher price and not losing business to other similar firms (Think Coke.) In my opinion a brand is one of the most powerful competitive advantages a business could have. This is because for one, a strong brand name is extremely hard to replicate. As a side note, i believe a brand is only beneficial for investors if it allows the company to charge a higher price and not lose customers or results in larger sales volumes. On top of this, the brand may not be bought. For example, if it's been internally developed, the brand may not be directly recognised by accountants in the balance sheet. According to Ben Graham in his classic text "The Interpretation of Financial Statements" he says that the value of an intangible may not truly reflect its potential. Rather, he suggests you look at the earnings power of it.

This is what Warren Buffett saw when he started buying large stakes in The Coca Cola Company in the 80s. Everyone was looking at the same financial statements but Warren saw that the company had a brand name that was worth billions, potentially trillions which wasn't directly nor fully reflected in the statements. The opposite of a franchise is a commodity type business (think Airlines). These businesses  are characterised by excessive competition and no price coercion what so ever. Typically, you want to stay away from these businesses without economic moats (if you want to understand economic moats to a much greater extent i suggest you read Pat Dorsey's - The Little Book That Builds Wealth.)

 A Growing Stream of Free Cash

Free cash flows are the flows that will eventually end up to owners of the business. In recent times, the DCFF/E model(s) has become popular because earnings are subject to management discretion. For example, a company can directly reduce expenses through changing the useful life of a depreciable asset such as PPE (by increasing the useful life from say 5 years to 10 years will reduce the depreciation expense.) As the value of the business is simply the amount of cash one can get out of it, growing free cash flows are ideal (not going into too much detail here).

Simple, Understandable

I like businesses which are simple. Like Warren, i too, can't understand complicated businesses. A simple business is much easier to understand allowing you to also obtain a stronger grip on its future prospects. Peter Lynch once said that he liked simple businesses that any idiot could run, because someday one will.


Stable—The Basic Business Changes Little Over Time/ predictable earnings

A stable business such as Coca Cola means that earnings are more easily predicted. A business which is susceptible to constant change isn't ideal because it means earnings are much harder to foresee with a similar degree of certainty.

Consistent, Repeated Purchases of Product or Service

A wonderful business is one that sells the same product over and over again. Think Wrigley's chewing gum. It is attractive because it allows the business to not need to outlay capital expenditures or research & development and all the rest of it. Essentially, it reduces the expenses of the business.

This is just a short summary of Mr Mihaljevic's more comprehensive list. I elaborated a little more on the first point because i believe it's a very important one which i spend most of my own time on analysing.

Viewing a stock as an "equity bond"

When you turn the P/E ratio on it's head you get the earnings yield. The earnings yield is a useful number to compare to other investment returns such as a bond (If you don't like the P/E ratio you can use CFO instead). A P/E of say, 20, would imply an earnings yield of 5% (1/20). On the other hand, a P/E of 12 would imply a earnings yield of  8.33%. When you compare the two, the latter is preferred because it's a higher yield relative to the price paid. Therefore, by implication, a lower P.E is preferred, ceteris paribus.

When you obtain the earnings yields for your stocks you should compare it to "risk-free" returns such as one would earn on a typical 10 year Gov bond. If the yield is less than the risk-free rate, You'd want to start asking a few questions such as growth rates in the yield.

Peter Lynch, a famous Mutual Fund investor who popularized the PEG ratio, said that if the earnings yield + dividend yield when summed was lower than the stocks P/E ratio, then the stock could a suitable candidate for further research as a possible investment. 

 The main difference between the earnings yield (when viewed in this manner) and the bond is that the bond's rate is fixed whereas the stocks yield isn't. Ideally, you want to analyse the potential growth in the yield, and the risk of it (chances of it materialising).

Happy hunting during the reporting season :)