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Hi guys, just a quick update on my previous post on HLF. I am afraid that I have left out certain information regarding how banks work etc, and that it might be new looking at the balance sheets & profit and loss statements of bank.

There’s an active discussion at Value Buddies, a local investing forum, which I recommend you check out if you need clarifications. I have already covered some key points over there such as:

  1. How HLF generates its revenue
  2. What drives the earnings of HLF (and other banks)
  3. Why book value is used as a approximation of intrinsic value
  4. Ability of HLF to pay out dividends
  5. Impact of property cooling measures on HLF
With regards to point 5, I will include a post another day to detail my views.
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For those in tune to the financial turmoil, you will need no introduction to the insane roller coaster ride that equities market have been put through the past month. Yet amid this madness, is there value to be found?

Now, for those who are true value investors, perhaps the most important lessons that we learn is that the mood of the market is akin to a pendulum. Market confidences invariably swings from wild optimism to irrational pessimism. For a quick assessment of the market “temperature”, here are some other reference points that you can look out for:

If you find more ticks on the left hand column, you might want to hold onto your checkbook.

There’s no denying that the markets are extremely fearful right now. The marketing is swinging widely – down 500 points one day, up 400 points the next. And yet in all this panic selling, I believe there lies a compelling and unmistakable opportunity in high quality large cap US equities.

The Compelling Case For US High Quality Companies

To set the record straight, when I refer to US High Quality, I am referring to companies with strong franchise values like McDonalds, Coke, Johnson & Johnson, Microsoft etc. They are typically characterized by:

1) Strong consistent free cash flow generation

2) Competitive advantage aka “economic moat” present

3) Needs little or no debt to run

As value investors, the source of our confidence and our ability to read through wild price swings invariably falls to our valuation of the company. If we have a reasonable estimation of the intrinsic value of a company with an appropriate margin of safety, it represents a worthwhile investment no matter what the world tells us.

In this aspect, the case for high quality US stocks have never been more compelling.

The valuations of these companies are startling. Many of these large cap high quality companies are trading at their historical lows if you were to judge them based on valuations. Furthermore, many of these companies have extremely healthy balance sheets, with enough cash to weather them through the potential storm. Even the US Banks which were hard hit by the sub prime crisis are in a much better state, having been recapitalized.

Whats more amazing is that many of these companies are earning as much, if not more than what they did before the crash in 2007 – 2008.

I don’t know about you, but I find it amazing that a company like Starhub is trading at a PE Ratio of 18~ whereas a company like Microsoft is trading at a PE ratio of 8.9. Don’t get me wrong – I like Starhub, but the valuations of these large cap high quality stocks are too compelling to ignore.

Concluding Thoughts:

One of the biggest arguments I hear against buying equities now it’s better to wait a while more for the markets to stabilize – as dark clouds loom over the horizon. After all, prices might continue to plunge. However, I must caution my readers of the naivety of such an argument. Firstly, seeing that a person could not predict the downward surge of prices a month ago, why would he or she suddenly be gifted now with the ability to see the future? Secondly, earning a good return on our investments does not equate to buying at the absolute bottom.

Sure, it would be nice if I could buy at the bottom and sell at the top. However, wishing ain’t going to make it happen.

In the end, our ultimate goals as value investors was never to pay the cheapest price possible for a good investment. Rather, it’s to pay a reasonable price for a good company. As such, I believe that large cap, high quality US equities presents such as investment that’s just too compelling to ignore.

Disclosure – Author is long MSFT, CSCO, WFC.

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A few people commented to me that the market looks “volatile” & “dangerous” in the next few months and that we should wait and see before things get better.

Well, I understand how it might seem. The unrest in the Middle East, Libya, the Tsunami in Japan, the end of QE2 etc. The list goes on and on.

However, I would like to point out three problems with trying to predict the future.

Firstly, why didn’t you tell me this 3 months ago? Secondly, considering that you couldn’t predict the market 3 months ago, why would you be right this time round? And finally why on earth would the market be better 3 months later?

No matter what the media/newspaper/friends/books have you believe, very few people actually are able to predict the future with any degree of certainty that is useful to you or me. I would be extremely suspicious of anyone claiming to be able to do so in any capacity.

And the truth is, predicting the future is not a prerequisite of successful investing.

If your going to invest for the long term, through out the traditional definition of risk. Risk is not measured by beta, standard deviation etc.

Risk is the permanent loss of capital. 

My advice?

Take a moment to look through your analysis again if need be. Run through the calculations to make sure they make sense. Than, once your done, close your books and turn off the TV.

As Warren Buffett once said  –

Wall Street makes it money on activity. You make your money on inactivity.

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I just updated my main webpage to include a financial report of Johnson & Johnson so do check it out.

Johnson & Johnson Report

Also, its come to my attention that I didn’t update the Lubrizol Corporation link properly on the right hand side of the page. I have since corrected it.

Before investing in pharmaceutical companies, its important to know the pros and cons of the industry.

Big pharmaceutical companies typically have wide moats and attractive financial strength. Most of the global pharmaceutical  companies post Returns on Invested Capital of > 20%. They also have little debt on their balance sheets and plenty of free cash flow generation.

However, developing drugs is extremely costly and time consuming. Clinical testing phases of drugs can take upwards of a decade. Whats worst is that these expenses does not guarantee the success of a drug. A company can pump in a considerable amount of money into research with no guarantee of return.

Once a drug is developed and approved by the FDA, they normally enjoy patent protection. This typically lasts about 8 – 10 years.

Armed with this knowledge, one should look for the following traits in pharmaceutical companies:

  • Companies which have a diverse range of drugs, and that have considerable patent time left.
  • Companies that are actively developing new drugs to refill their pipeline.

Due to their strong financial positions, many pharmaceutical companies are choosing to acquire smaller companies to replenish their pipeline. This really illustrates why free cash flow and low debt levels are so important. Companies that are highly leveraged and generate little free cash flow would be unable to fund such acquisition’s easily.

Conclusion:

I am bullish on healthcare companies in the long run. As we face an aging population in developed nations around the world. Furthermore, as developing countries improve their standards of living, there will also be a corresponding increase in demand for better healthcare.

However, it’s important (to me anyway) not to get too carried away with macro trends. Always ensure that the companies you invest in are trade at a reasonable valuation no matter how rosy the outlook maybe.

The author is long JNJ.

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I came across an interesting research report regarding office REITs recently. It recommended a strong buy for the sector. One of the points caught my eye: 40% leverage is the new norm.

Certainly caught my eye thats for sure (I added the red font color by the way).
Being the astute reader that you are, you probably guessed by now that I don’t really like REITs.

Here’s why:
1) The nature of the business itself – I certainly understand how it works, but I don’t see how it makes sense. I am fine with the idea of using moderate leverage to fund growth – provided that the loans eventually get paid off. It seems illogical to take a substantial bank loan, agree to pay out 90% of whatever income you have to unit-holders, and than seek refinancing again in 3 years time at whatever interest rate exists.

2) The dilution of existing unit-holders – After maxing out their loan facilities, REITs than turn to their unit-holders for funds.  I have nothing wrong with the issuing of shares (I must admit, I don’t look favorably upon companies that dilute their shareholders), but again, I rather not be forced to buy new shares of companies I already own a certain percentage in just in order to maintain my X% stake of the company.

3) The downside – Low interest rate environments aren’t going to last forever. Period. It might not end this year, next year or eventhe year after that, but eventually governments ARE going to have find a way to pay off their debts. When that happens, it won’t be a pretty picture for companies that look for refinancing.

To make a long story short, this industry makes me uncomfortable. When I close my eyes and think, if the stock market closes for 5 years, would I really be confident in that X REIT would still be around? I can’t see it with a level of confidence I am comfortable with.

Do let me know your views on REITs.

PS: Nothing against investors of REITs personally. Like all things, I could be wrong and I dohope that they continue to do well for all of you out there. Just my personal opinions of the situation.

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