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Archive for the ‘Research Reports’ Category

Popular Holdings is a common enough household name in Singapore and in this post, I will bring you through my thought process when I examine a business. I have attached the operations and financial review from their latest annual report, and for the sake of brevity, I will only be providing some financial ratios.

My own view is that you should never look at the price of a business before deciding whether to invest in it. The price action (or market capitalization) reveals very little about a business, and that should be your last port of call. Price is what you pay, value is what you get.

It is therefore important to establish what a business is worth before deciding whether to invest in it or not.

Balance sheet strength is what I look for instinctively, and I always examine how leveraged a business is. Although leverage can help boost profits, it can be a different situation in times of financial stress. In this case, Popular Holdings is conservatively financed with a debt to equity ratio of 0.10.

Next, I look at how much equity the business has. Two businesses earning the same amount of money each year are worth a different value if they have differing amounts of equity. In this case, my focus is on liquid current assets.

In this case Popular Holdings had:

Current Assets $290.2 million
Total liabilities $146.3 million
Estimated Worth $143.9 million

 

This is a quick back of the envelope test that I use when I first look at a business, and before I decide whether it warrants a second look. I normally adjust the values, placing more emphasis on cash and equivalent assets, and impairing assets such as inventories. Next, I do not include non-current assets to err on the conservative side in my calculations. I will include a more in-depth discussion on this in the future.

So now that we have established the business is sound, I turn to look at the profitability of Popular Holdings. If you look at the review of the financial results, you will notice that results for FY 2009 – 2011 were erratic. A little bit of digging reveals that this was due to a non cash impairment of $28.2 million taken in FY 2009, and its subsequent reversal in 2010 ($21.7 million) and 2011 ($6.5 million).

Excluding the effects of the non cash impairments would result in about a net profit of about $10.7 million in FY 2009, $9.5 million in FY 2010, and $17.3 million in FY 2011.

Based on the latest closing price of 3rd August 2012, Popular Holdings has a market capitalization of $197.6 million. Bearing in mind that the figures I used were from the annual report from FY 2011, and not the latest financial results from FY 2012, whereby it reported a net profit of $31.1 million.

So currently, we have a business that’s trading at a trailing P/E of ~6.4, and that has liquid assets of about $143.9 million (based on audited financial results from FY 11). You are essentially obtaining a business for ($197.6 million – $143.9 million) for $53.7 million, and that has generated an average of about $19.3 million in net profit in the past 3 years.

How do I decide whether it makes sense to invest in a business?

Once I have done the necessary research to ensure that I am comfortable investing a company, it really comes down to the price that I am willing to pay. In this case, I want to invest in a business that has an earnings yield (inverted Price/Earnings Ratio) that is at least double that of the triple AAA corporate bond rate (~ 5%). In other words, I want an earnings yield of at least 10%.

In this case Popular fulfils my criteria. If it pays out roughly half its earnings in dividends, giving me an equivalent dividend yield of about 5%, Popular Holdings will only need to appreciate about 5% annually to give me a return of 10% a year. The value of its liquid assets provides an additional draw, making the business much more attractive to own considering that you are paying very little for what essentially is a very profitable business.

Final Thoughts:

This is a very brief summary of my thought process when I look at businesses. Other factors which I look at (but were not discussed) include Free Cash Flow, whether the business is capital intensive and so on. The purpose of this post is to provide you an idea of how I go about researching businesses.

Disclosure: Long Popular Holdings.

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As investors, it’s easy to get caught up in the hysteria and follow the herd. And yet, to earn a return that is excess of the market’s requires us to act against conventional wisdom. Markets are whimsical and it is my firm belief that it should never replace independent thought, especially when it comes to the critical process of capital allocation.

As we are a value based fund, we tend to invest in unloved and controversial companies that are trading at a depressed price compared to what we think they are conservatively worth. Many of these securities continue to trend downwards in price after our initial investment, and it is not uncommon for us to add to our purchases as prices continue to slide. This in turn may lead to us under performing the market in the short run. However, I must reiterate that the fund takes a long term view when it comes to common stocks, and seeks to invest in businesses that will continue to be profitable for many years to come.

As you may have noticed, we have significant positions in various financial institutions based in the United States. It’s interesting to note that many of these institutions are trading at a discount below tangible book value. Furthermore, many of these companies are trading at prices close to that of their bottom in 2009 – an interesting notion considering many of them are in a much better financial position than they were two years ago.

Let there be no mistake that these companies still face significant challenges in dealing with their legacy issues. However, we would like to point out that credit quality has generally improved, and charge-offs due to bad loans are showing a significant and steady decline. Furthermore, many of these financial institutions are far less leveraged, and far more cautious than before. We do not expect them to earn the outsized returns on equity they did in the preceding decade. However, we consider it reasonable for them to earn at least a 1% ROA (Return on Assets), or 10% ROE (Return on Equity) with  10x leverage going forward into the future.

With that, some of you may have realised that financial institutions in the EU are trading at historically depressed valuations. So why isn’t there an “opportunity” of the fund to allocate capital there? The answer is simple: leverage.

(Photo Credit: Fortune)

At the present time, we see little margin of safety with the banks so heavily leveraged. Make no mistake that the challenges faced by the European Union are indeed severe and deeply worrying. I have no extraordinary insight regarding the impending crisis. Suffice to say, it pays to be more cautious than usual when allocating capital.

Although the macro situation looks exceedingly grim, investors can take solace in an interesting phenomenon – high quality companies that are conservatively financed, and that possess long term track records of generating wealth for shareholders are on sale. We are confident that the companies we currently own in our portfolio were purchased at attractive valuations and will go on to do exceedingly well going forward into the future.

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Here’s a presentation I prepared personally outlining the compelling case for investing in Hong Leong Finance. It’s my second best idea with regards to Singapore equities this year and I hope you enjoy it.

The underlying idea is simple, Hong Leong Finance (HLF) trades at a significant discount to book value. If you look at the long term track record of the company, it is not unreasonable for us to expect the company to earn at least a 1% return on assets, and trade at at least tangible book value. Check the presentation out for more info.

Disclosure – Long HLF


 

 

 

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The Compelling Case for Bank of America

Bank of America is probably one of the most hated and reviled corporations in America right now. They are the poster boy for just about everything that’s wrong with the American financial system – from corporate greed, TBTF banks, excessive compensation etc. However, with all the emotions involved, it is important for us to take a step back and examine whether the relentless pressure on BAC is truly deserved.

Market Capitalization of BAC – Has it really lost 2/3 of its value in a year?

Here’s a disclaimer, if you’re going to consider in BAC, you should at least have a basic understanding of how the banking system works, and how banks in general generate their revenue. Furthermore, it’s important to at least have a grasp of the underlying failures of the financial system that eventually led to the subprime crisis, and an understanding of the credit cycle.

I will be attaching some links at the end of my post to provide further reading if you’re interested.

Brief Summary of BAC:
BAC 2010 Operating Results:
Net Income: -$2.238 billion
EPS: -$0.37
Book Value Per Share: $21.62
Return on Assets: -0.16%
 
Current Valuation:
P/B: 0.3
Industry Average: 0.7
BAC 5 Year Average: 1.0
 

 The central thesis for investing can be summarized:

“…Its earnings power has been disguised by the intense provisioning for loan losses. But when the provisioning gets back to a normal level, you’ll start to see that incredible earnings power come down to the bottom line. And it’s as simple as that.”

Bruce R. Berkowitz, November 25, 1992

Interestingly enough, Bruce Berkowitz and Warren Buffett made a similar investment in Wells Fargos during 1992 when the housing bubble in California bursts, leading to similar write downs by Wells.

Here’s a simple overview of what Bruce Berkowtiz is driving at:

Despite the massive write downs on their real estate assets, Bank of America is an immensely profitable company with significant earning power. Almost every American institution or citizen does some form of business with BAC and it’s an integral part of the financial institution. Charge offs have been steadily declining since late 2009, and once BAC clears through its legacy loans, the underlying profitable businesses of BAC will be realised.

Bank of America now is vastly different from the Bank of America in 2008. The CEOs have changed and the company has gone from its “merger” mentality to one of consolidation and restructuring. They are making massive charge offs on their non-performing loans and assets. They are also selling off assets and shoring up capital.

Loans made in recent years are much stricter than they were before. One of the reason (though not the only) why people find it difficult to get loans these days is because the criteria for  making a loan has gone from incredibly easy to being infinitely hard. However, these means that the overall quality of loans that BAC has been making has drastically improved.

Now, BAC still has legacy loans made by Countrywide, one of the most notorious subprime lenders. However, it’s important to note that all loans have “half-lives” and BAC is slowly burning through these legacy loans.

Under normal circumstances, it’s not unreasonable to expect BAC to earn a 1% return on asset, or 10% return on equity which works out to be roughly around $2 per share. Contrast this to its current $6 a share price. Furthermore, BAC is selling at a 40% discount to its tangible book value (excluding goodwill and intangible assets), which works out to be about $15. Under normal operating conditions, it’s not unreasonable to expect BAC to sell for at least tangible book value, giving us a base price of around $15.

Even so, there are many challenges that are involved in investing in financial institutions:

a) We still do not fully understand or trust the numbers
b) Financial regulatory reform may reduce earning power
c) New Basel rules may require more capital and reduce profits
d) There may be a double dip recession
e) The unemployment rate may go higher and create more defaults
f) Commercial real estate prices may fall dramatically
g) Banks are still not marking loans in their books properly
h) Residential real estate prices may fall further
i) States and municipalities are in bad shape
 
- Francis Chou Semi Annual Report 2010
 

It’s important to note that investing in BAC requires a long term horizon of at least 3 – 5 years as there remains many unresolved issues.

Concluding thoughts:

Many people are familiar with Graham’s view on investing, and the strict definition that he placed upon it. However, he went into great lengths to disabuse the notion that all speculation was inherently bad. There is after all intelligent speculation just as there is intelligent investing. Situations which involve unintelligent speculation include:

  • speculating when you think you are investing
  • speculating seriously when you lack proper knowledge and skill for it
  • risking more money in speculation than you can afford to lose

Any investment in Bank of America involves a leap of faith that most at the very least, makes it speculative. However, I believe that as at least for the next few years, the quality of earnings on banks will improve, and that management will be far more risk adverse considering the fragile state of the economy.

Notes on how I structured my investment in Bank on America:

Small percentage of portfolio – currently 2.5 – 3%, potential to move up to 5% if the price is attractive
Current price: $6
Estimated intrinsic value: $15 – $30 (1x – 2x tangible book value)
Holding period – 5 – 8 years
 

I have a certain aversion when investing in financial institutions as they are inherently more complex than the average company. If there is one thing that I learnt from the subprime crisis, it is simply impossible (and foolish) to be absolutely sure whether a financial institution can whether the storm. Obviously, due diligence is done as humanely possible beforehand and the basic leverage ratios/long term debt holdings are examined.

As a result, I decided to purchase a protective put option. Let me illustrate it with the following example (date taken from the close on 21/11/2011).

BAC: $5.49
BAC Put Option, $4 Strike Expiring Jan 2013: $0.87
Total cost (100 shares): $6.36 * 100 = $636

A put option gives you the right to sell 100 shares of BAC at $4 before the strike date in January 2013. Think of it as an insurance policy that you pay for in the event that BAC collapses. The price that you pay represents the premium that someone would need in order for him to take that risk.

There are 3 main scenarios that might happen:

BAC hits the bottom range of our expected price – $15
Our profit per share is
$15 – $5.49 – $0.87 (price paid for the put option) = $8.64, representing a return of 135%
 
BAC hits the top range of our expected price – $30,
Our profit per share is
$30 – $5.49 – $0.87 (price paid for the put option) = $23.64, representing a return of 371%
 
BAC goes bankrupt and the common stock becomes worthless,
Exercise PUT option, sell shares for $4 per share.
Our loss per share is
$6.36 – $4 = $2.36, representing a loss of 37%
 

In this way, I structured my investment such that the risk reward ratio is heavily skewed towards my favour. Most of my capital is substantially protected in the event that BAC gets wiped out. However, in the event that BAC returns to its normalized operating profit, and earns a reasonable rate of return, I stand to earn a significant return on my investment.

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Microsoft is one of my favorite companies. It has a solid track free cash flow generation, decent growth and almost no debt on its balance on its sheets. And best of all, its trading at a ridiculously low valuation over fears that its lagging behind in the technology industry.

Look here if you want a great presentation by Whitney Tilson on Microsoft:

Whitney Tilson Presentation on Microsoft

While I agree that some of the criticism of Microsoft is valid, people seem to be forgetting that Microsoft has an incredible franchise with Offices and Windows. I won’t go into the details (you can find it in the presentation) but suffice to say, I feel that Microsoft is trading at an attractive valuation relative to its current performance.

Let’s look at the fundamentals of the company:

 

Despite all the negative flak,  Microsoft has been growing its bottom line really well over the past few years.

Its average annual growth rate in earnings per share is 13.7%.


Microsoft has done really well in this respect. It has little debt on its balance sheets and recently issued long term bonds at record low interest rates.


Returns on Invested Capital averaged 27.4% over the past few years.

Similarily, Free Cash Flow has been growing a steady rate of 9.3% on average per annum.

Conclusion

One of the criticisms I hear about Microsoft is that the stock hasn’t moved anywhere for the past 10 years (its been hovering around $20 – $30). I would like to highlight an extremely important point in investing.

“Price is what you pay. Value is what you get.” – Warren Buffett

Prior to 2008, Microsoft was trading at an average PE of 25 i.e. it was trading at an extremely generous price relative to its intrinsic value. One of the key principles of value investing is to always demand a margin of safety.

Always remember, no investment is ever worth overpaying for – no matter how good it looks.

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