“Everything should be made as simple as possible, but not simpler”         Albert Einstein

[Posted by sunztzhe > Nov 24, 2015 12:43 AM | Report Abuse

Assets of any company will generate a return n postive returns will contribute to retained earnings n pay dividends or give bonus issue ...so earnings growth will drive share price up..likewise earnings decrease will drive share price down..so focus on Earnings per share..and simple PE multiple...of course others may choose IV, EV/EBITA etc etc..but i keep it simple ..just EPS, What PE multiple..what is forward EPS n forward PE multiple based on current price ]

I started investing in the stock market more than 30 years ago. First like most people, I just listened to the rumours and hypes in the market to decide which stocks to buy. You know those days you went to the Broker firm and many punters sitting and standing around and talked about which stocks would go up or down? Which director of which company said his stock would be fried up? Punters would just follow and buy whatever crap stocks being promoted, most didn’t even know what business the company is involved in, let alone to bother if the company made money or not. That experience of course didn’t end well for my investments.

Later I started to read some magazines such as Malaysian Business, Investors etc. I learned some simple valuation metrics especially price earnings ratio and price-to-book. So I happily used them to gauge if a stock is worthwhile to buy after hearing the rumours in the market. That was a big improvement, even in today’s standard, as you can see, few have any fundamental investing knowledge, nor care to learn anything about it.

Unfortunately, that experience in using PE ratio did not turn out well for me too. I never got rich. In fact as far as I can remember, I was always short of money even though I worked as a professional, a civil engineer who supposed in the higher bracket earnings then.

The opening comment above was posted in my article published in i3investor here:

http://klse.i3investor.com/blogs/kcchongnz/86545.jsp

In the same article the writer of the comment posted a few more comments questioning the usefulness of the discounted cash flows analysis, DCFA, and suggestion that we should use the earnings growth and PE ratio for our investment decisions.

First of all, I do agree that there are problems in the DCFA as mentioned by the writer of the comment at length in my previous post. Many great super investors do not use it in their investing decision, and some do use. Warren Buffett, though he said the value of a company is the discounted future cash flows to the present, I do not know if he actually carries out any DCFA.

I have also never disputed that some investors have made good returns using purely the PE ratio. I do use it all the time as a quick and dirty way to have a feel of if a stock is selling cheap or expensive.

The first academic research I have read on P/E ratios was an article written in late 1970s which Sanjoy Basu discovered that stocks with low P/E ratios have significantly higher returns than stocks with high P/E ratios, even after accounting for risk. Subsequently there were numerous other academic research showing that investing in low P/E ratio stocks have yield extra-ordinary returns without the additional risks associated when compared to the broad market.

I have also written an article on investing in Bursa about the low PE ratio investing strategy, using a portfolio of 104 high dividend yield stocks for a five-year holding period from 2009 to 2014, in i3investor in the link below:

http://klse.i3investor.com/blogs/kcchongnz/62822.jsp

The results were positive with my finding as below:

“The broad KLCI index has increased from 1260 to 1819 at the close on 24/10/2014. The total return (with the assumption of 3% dividend every year) is 51%, or a compounded annual return (CAR) of the market is 10.6% as shown in Table 1 in the Appendix. The total return of the portfolio of 104 stocks is an average of 181%, or a CAR of 17.6% with a very high standard deviation of 17%. The cumulative average return of the portfolio is hence 3.5 times that of KLCI of 51% and the CAR 70% more than the market return of 10.6%.“

If I were a fund manager doing quantitative investing, I would probably us this as one of my strategies of buying a diversified portfolio of a few tens of stocks using the low PE ratio screen. I believe the outcome of the return of the portfolio will be better than the broad market. However, I am just a retail investors and have a portfolio of about 10 stocks. Choosing the ten stocks to invest, I definitely would not follow the fuzzy earnings growth and simplistic PE ratio, although they will be something to take into consideration in my entire thesis of the investments. I also would not encourage you to do so. Here are the reasons why.

What is PE ratio? What is it made up of?

“If something is easy to compute and understand, it is extremely unlikely that the market will misinterpret it. Therefore, such information will not, by itself, provide evidence of mispricing.”

The P/E ratio is supposed to tells investors how many years' worth of current earnings a company will need to produce in order to arrive at its current market share value.

P/E = Share Price / EPS

The first part of the P/E equation - price - is straightforward. We can be fairly confident what the market price is. On the other hand, coming up with an appropriate earnings number can be tricky. You have to make a lot of decisions how to define earnings.

Let me take the recent releases of quarterly reports of some of my favourite companies in my article below to elaborate what I mean.

http://klse.i3investor.com/blogs/kcchongnz/45373.jsp

For the purpose here, I would just base on the financial statements without taking too much trouble to get too detail into the footnotes. The net profits I use below are all before the "Other comprehensive income" as reported.

KNM

KNM reported its 3rd quarter 2015 financial results ending 30^th September 2015 as summarized here:

It made RM42.2m as "Net profit for the period", or 2.4 sen per share, in net profit for the nine months. How come the company only received a net cash inflow of the year of only RM3.6m?

An examination of its cash flows statement shows that there are two major items which makes its net profit illusive.

1. There is an “unrealized gain on foreign exchange of RM88.7m; something which “can be seen but can’t be eaten”. It isn’t cash in the pocket. What use is this “earnings” in the PE ratio?
2. There is a “Gain on disposal of subsidiaries” of RM22.2m.
   1. Is that really a “gain” if these subsidiaries were bought at say RM300m five years ago with a loan and have been losing money for a few years and now disposed of?
   2. Can KNM keep on disposing of subsidiaries and continue to make “earnings”?

KNM has been a very high growth company in the 2000s. It makes profit every year. But why is that its net borrowings keep on increasing, despite various rights, warrant issues, and private placements? Where has the “earnings” gone to? Is that “E” real?

I haven’t talked about KNM actually spent another RM27.4m for buying property, plant and equipment (PPE) to keep its door open for the three quarters ending 30^th September 2015.

What good is this earnings of RM42.2m, when KNM only receives a net cash of RM3.6m, but have to find more money in the order of RM50m somewhere else to pay an interest payment of RM24.8m, and buying PPE of RM27.4m for the nine month period?

5 years ago if you were to invest in KNM when it was selling at about RM3.00 apiece, with a PE ratio of about 25,but high growth expectation, you would have lost 82%! I haven't talked about when KNM was flyng high with its high earnings and growth seemed unstoptable 10 years ago when it was selling at an adjusted price of more than RM8.00 apiece.

Let us look at another company in the above link, Guan Chong Berhad.

Guan Chong

Guan Chong’s third quarter net profit was RM21.5m, a great turnaround from a loss of RM13m in the previous corresponding quarter. EPS for this quarter alone is 4.6 sen, and if annualized, would be 18 sen per share. Its share price shot up from about 87 sen to more than RM1.20 just before the announcement. It closed at RM1.08 on last Friday 27^th November 2015.

However, it “lost” cash of RM79m for the nine month period. An examination of its balance sheet shows it receivables has increased by 122% from RM207.3m to RM460.1m, although the revenue increases by just 31%.

Oh almost forgot here. I haven’t considered Guan Chong has to find another additional RM20.5m, on top of the RM79m for capital expenses for the nine month period yet.

As expected, it total borrowings have increased by a huge amount by approximately the same magnitude.

Is that sudden surge of earnings any good when there is no cash inflow at all, and in fact, a huge cash outflow? Or would it suffer the same faith as before as discussed in this link here:

http://klse.i3investor.com/blogs/kcchongnz/67199.jsp

Actually I don’t know about Guan Chong’s business and its operations well enough. It has been a high growth company too. However, its business appears to be very complicated and I am not sure if it is a chocolate manufacturing and distributing company or a speculator on cocoa. But looking at its quality of “earnings”, I get scared and will straightaway put it under the “difficult” pile and just avoid it.

About 4 years ago, if you were to invest in GCB at about RM2.00 at a PE ratio of less than 10 and very high growth then, you would have lost 46%.

Let us look at another of my favorite, London Biscuits.

London Biscuits

London Biscuits earnings grows again to RM18.2m for the financial year ended 30^th June 2015. However, it could not even get enough money from its customers to pay for its staff’s salary of RM28.9m for the year. It is short of RM20m cash for its operations.

Trade receivables increased by 76% to RM177m, while revenue only increased by 11.8%. It will now take an average of 135 days to collect it, compared to 102 days last year.  Why is there such a high growth of receivables relative to growth in revenue? Are they all collectable?

Together with the money spent on purchase of PPE of RM21m, it has to find the additional RM41m from somewhere to keep its door open in 2015. Yes, the money comes from additional borrowings and private placements from some kind souls.

Actually prior to the last financial year, London Biscuits has a lot of surplus of cash from its ordinary operations, very close to its net earnings. However, it spent huge amount of money on PPE, so much so that there is negative free cash flows every year.

Is there any good of this earnings and earnings growth? Is there any good even if it has good CFFO when it has to consistently spend huge amount of money in capital expenses, leaving nothing behind, but has to keep on borrowing and issues new shares to survive?

About 10 years ago if you have inveted in London Biscuits at about RM1.80 when its PE ratio was less than 10, also with a high growth expectation, you wold havelost 55%!

Its first quarter 2016 results has yet to come out.

Ivory Properties

Ivory made a net profit of RM8.8m, or 2 sen per share for the three quarters ending 30^th September 2015. Out of the RM8.8m, RM7.5m is from the gain from disposal of an investment in a subsidiary, and then it has to spend another RM1.5m in purchase of PPE.

This "Gain from disposal of an investment" was reported in the ordinary business I presumed as it is not under the "Other comprehensive income" in the Income Statement, and it was netted off from the cash flow statement, and hence that was how I deduced.

Does it really has the cash left from this “Earnings”? Can Ivory continue selling investments in subsidiaries to book earnings? If not, what good is this “earnings”?

SMTrack

The SmartTag in my previous list of favourite stocks has become SMTrack now, but has anything changed? Maybe.

In its second quarter results ended 30^th September, SMTrack has a revenue of 187k. Yeh, k is thousand, and not million, but its net profit is more than double that at 396k, or 0.18 sen per share and it was booked as operating income, and net profit is of the same amount.

Obviously it can’t be true “earnings”. The main reason of the earnings is due to the disposal of a subsidiary of a gain of RM3.6m, and unrealized exchange gain of RM0.5m. Is it right for the company to report it as "Other operating income"?

But still it has to find another RM2m for this two quarters to keep its door open.

So where is the beef? What good is this “Earnings”? Can SMTrack continues to sell subsidiaries and gain from foreign exchange every year in future?

Other companies

What about the other companies described in the link above; Asia Media, CSL, Hibiscus, and MPCorp?

Shall we be overjoyed about China Stationery Limited’s earnings of RM22m the last quarter ended 30^th September 2015?

For other companies, are there any earnings to talk about for the quarter just passed in the first place, or even the last few years?

In the past, Hibiscus sold some shares of a joint venture to a third party and recognize a gain, or earnings E of RM13.5m during the last quarter of 2013 when the revenue was only RM6.7m. That was the only earnings, one of the most ridiculous ones so far. But is that really earnings?

If you were to "invest" in Hibiscus less than two years ago with the high earnings expectation, and bought it at around RM2.70, you woule have lost 91% of your money in less than 2 years!

Asia Media played with its capital expenses to boasted revenue and fake profit E in 2012. That was the fakest earnings I have ever heard of. Naive speculators and punters taking this PE ratio and growth in earnings expectation at face value lost huge amount of money, played out by the insiders, syndicates and even professional analysts and investment bankers.

Conclusions

The DCFA definite has its flaws and it is not absolutely necessary in stock valuation. P/E ratio has much more and big shortcomings that investors need to consider when using it to assess stock values. In fact, using the simplistic PE ratio to chase after hot stocks can be very dangerous for one’s financial health as shown in the above.

There is no best valuation technique in the stock market. Certainly P/E ratio is not the best, far from it. There are proven super investors and established fund managers who have said DCFA is an essential valuation methods as described in the article below.

http://klse.i3investor.com/blogs/kcchongnz/86781.jsp

In my opinion, it is advisable to use a variety of techniques to get a fuller picture of stock valuation.

Knowing how to use some of the valuation techniques definitely help you to avoid almost all the lemons in the stock market, and that would definitely enhance your investing outcome tremendously.

If you are interested to learn the various valuation methods for a small fee, please contact me at

ckc14training2@gmail.com

“Tis goeth down to a fundamental aspect that “An investment in knowledge pays the best interest”

- Benjamin Franklin

K C Chong