How To Evaluate The Quality Of EPS and find out what it's telling you about a stock.

Examining Earnings Quality

Overview  

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

EPS Quality  

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned.  A reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. 

1.  Positive earnings but negative Operating cash flow.

• The company can show a positive earnings on the income statement while also bearing a negative cash flow. 
• This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. 
• A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected.
• "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long.

2.  Operating cash flow > earnings 

• If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS.
• In this case, earnings are of a high quality because the company is generating more cash than is reported on the income statement. 
• Reported (GAAP) earnings, therefore, understate the profitability of the company.

3.  Operating cash flow < earnings

• If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. 
• In this case, EPS is of low quality because it does not reflect the negative operating results of the company.
• Therefore, it overstates what the true (cash) operating results. 

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends.

• It is possible that an entire industry may generate negative operating cash flow due to cyclical causes.
• Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. 

• As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. 
• The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP EPS by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. 

Earnings increasing and Operating cash flow increasing > Earnings increasing but negative operating cash flow

The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. 

Operating cash flow > Earnings

The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. 

Positive Earnings but negative operating cash flow.

Luckily, it is relatively easy for investors to evaluate the situation. 

http://www.investopedia.com/articles/analyst/03/091703.asp

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

I throw my support for Tan Teng Boo to maintain the status quo in iCAP.

I welcome shareholder activism in iCAP.  This can only be good for this fund.  However, given the short notice of this new development, it would be good to understand the issues deeper.

Questions I pose to myself:

1. Has iCAP outlived its usefulness and its breakup or liquidation be beneficial to existing shareholders for the long-term??
2. Has iCAP managers proven themselves incapable of making a decent return?
3. Would iCAP having a dividend policy be beneficial to the long term investors of this fund?
4. Would iCAP buying back its own stocks that are trading at a discount necessarily improve market price of its stock?

1.  Has iCAP outlived its usefulness and its breakup or liquidation be beneficial to existing shareholders for the long-term??

iCAP was started in 2005 with a set philosophy laid down by Tan Teng Boo.  The early investors of iCAP subscribe to his philosophy.  The fund was set up to enable small shareholders to invest in the stock market managed by a proven fund manager.  There is a need for such fund to exist.  Therefore, iCAP plays a useful role for those small or big investors whose investing philosophy are aligned with that of Tan Teng Boo, its fund manager.

Therefore, my answer to Question 1 is NO.

2.  Has iCAP managers proven themselves incapable of making a decent return?

We should be wary of short term performances of funds or any investing.  The market volatility can be such that the performances of the short term can fluctuate widely.  Nevertheless, it is the long term return one should be focus on.  On this point, iCAP has more than delivered on its promise at inception to those who are long term invested in this fund.  It has delivered 18% compound annual return in its NAV since 2005.

Therefore, my answer to Question 2 is NO.

3.  Would iCAP having a dividend policy be beneficial to the long term investors of this fund?

iCAP has delivered compound annual returns to its shareholders 18% since inception.  Given its excellent performance since inception, it is rational and logical to retain all earnings to compound at these high rates of returns to grow your networth.  In any case, this objective was stated clearly by Tan Teng Boo when he started this fund.  

Therefore, my answer to Question 3 is NO.

4.  Would iCAP buying back its own stocks that are trading at a discount necessarily improve market price of its stock?

Share buybacks offer advantages and disadvantages.  However, these too do not guarantee that the discount to NAV of the fund will narrow either.  It is not unknown that there are companies that bought back their own shares with little impact on their share price.  In fact, for many, the stock prices even continue with their relentless decline driven by fundamental reasons.  Share buybacks by companies of their own shares are not without their controversies and complicities.

Therefore, my answer to Question 4 is NO.

Tan Teng Boo should mobilise the investors who share his philosophy who are long term invested in his fund to defeat the challenge posed by Laxey Partner.

Hopefully, he will be successful.  After having survived this in the 8th AGM, he will have time to rethink and continue taking this fund to a higher level of performance.  It is far better for Tan Teng Boo and the Board of iCAP to concentrate on investment performance than to worry too much over how to shrink the discount to the NAV of the fund which they have some or little control over.

icapital.biz founder may retire as its manager

Posted on 7 November 2012 - 05:38am

sunbiz@thesundaily.com

PETALING JAYA (Nov 7, 2012): Tan Teng Boo, managing director of Capital Dynamics Asset Management Sdn Bhd (CDAM) which manages icapital.biz Bhd, has announced his and the company's intention to retire as the fund manager of the closed-end fund listed on Bursa Malaysia, ahead of icapital.biz's AGM on Saturday.

This follows the nomination of three individuals, namely Andrew Pegge, Lo Kok Kee and Low Nyap Heng to be part of the fund's board at the upcoming meeting.

In a statement yesterday, Tan said having such individuals on the fund's board would threaten its continued success, which has been delivering an annual compound return of 18% per year since its listing on Oct 19 2005.

"The objective of the three nominees is not only contradictory to the long-term vision of icapital.biz, but also detrimental to the sustainability of the fund's future.

"Based on their previous track records, the three individuals are only concerned with short-term gains, while ignoring the interest of the majority of the share owners in the long run," he said.

Tan warned that if any one of the three persons is voted in at the AGM, CDAM will "seriously reconsider" its position as the fund manager and retire "because our philosophy, values and objectives are diametrically opposite to theirs".

"CDAM works hard at building sustainable long-term values, based on principles of integrity."

Tan also pointed to the track record of UK-based Laxey Partners Ltd, the firm of Pegge, which he described as "extremely disappointing".

He cited the share price of The Value Catalyst Fund, a closed-end fund launched by Laxey Partners in December 2005, which had plunged by 58% when it was suspended in June 2011.

"Another fund managed by Laxey Partners, The Terra Catalyst Fund, has consistently traded in discounts since it was launched in Feb 2008.

"In addition to its poor performance as a fund manager, Laxey Partners and Pegge were fined 1 million Swiss Francs by the banking regulator from Switzerland in 2008," he said.

Shares of icapital.biz closed up 7 sen at RM2.56 yesterday, with 789,300 shares traded.

http://www.thesundaily.my/news/534942

iCAP the Undervalued Closed-End Fund. What will be its outcome?

Here is an article to understand the events happening in iCAP at present.  Closed-end fund often trades at a discount inviting predators that are after short-term quick gains, rather than long-term bigger gains.

Canny Money Manager Spots Prey: the Undervalued Closed-End Fund

July 09, 1988|DAVID A. VISE | The Washington Post

ANNAPOLIS, Md. — It seems an odd place to plot the next wave of hostile takeovers.

But there in his airy Annapolis living room overlooking the calm waters of Crab Creek, Bob Gordon speaks of financial war. His prey: the investment companies known as closed-end mutual funds whose undervalued shares offer opportunities for short-term trading profits.

Gordon, a 35-year-old money manager who splits his time between Annapolis and Manhattan, is remarkably candid about potential takeover targets. "Scudder New Asia Fund is an obvious one to go after," Gordon said. "Scudder gave in on one before."

Identifying profit-making opportunities with relatively low risk is Gordon's specialty--and he pursues it day and night. With his fiancee sleeping nearby, Gordon regularly studies the tax code and other documents until 2 a.m., dreaming up new ways for clients of his New York-based Twenty-First Securities Corp. to boost after-tax returns.

"I see little glitches," he said. "When I was 12, I knew I wanted to do this. I like math, and this is a practical application of math. It is fun for me."

Gordon believes that he has identified a glitch in closed-end funds that makes them vulnerable to a hostile raid.

Unlike the more common open-end funds, a closed-end fund sells a fixed number of shares to the public and invests the proceeds in stocks and bonds.

Price Reflects Value

In open-end funds, investors buy their stake from the fund and sell it back whenever they wish. There is no limit on the number of shares, and the price reflects the exact value (net asset value) of the stocks, bonds or cash held by the fund at the time of a transaction.

Closed-end funds are more like industrial firms whose shares trade on stock exchanges--the price for a fund's shares is primarily determined by the demand for the fixed number of shares. Investors consider the underlying market value of a fund's holdings, but share prices for the funds are also influenced by expectations, emotions and other factors that often affect prices in the stock market.

Many of the closed-end funds are vulnerable to a takeover maneuver these days because the shares of these funds are trading at discounts of 20% or more below the market value of their holdings. The Securities and Exchange Commission recently launched a study to determine why these discounts exist.

To their horror, uninformed investors often find that shares in new closed-end funds quickly drop below their initial offering price and may continue to remain significantly below the market value of the fund's holdings.

There are several reasons.

First, the initial price includes substantial underwriting fees paid to the brokerage firms that market the shares.

Second, while these brokerages may support the price through active trading in the days immediately following the offering, the firms typically retreat soon after and use their capital elsewhere. Once the firms are no longer supporting the price of a closed-end fund, it typically drops.

High Management Fees

Another common factor affecting prices of closed-end funds are high management fees, which reduce returns, said Thomas J. Herzfeld, a Florida-based closed-end fund expert who is working with Gordon on possible plans to restructure closed-end funds.

What Gordon has in mind is the forced conversion of publicly traded closed-end funds to open-end mutual funds, or, in extreme cases, the forced liquidation of closed-end funds.

Gordon speaks of buying shares in a closed-end fund, presenting a restructuring proposal to fund managers and then giving the managers a severe "this is your one chance to save your jobs" warning. "Some of the guys are waiting for it to happen to them," Gordon said.

Although these strategies are not risk-free, they could produce stock trading profits for Gordon and other closed-end fund investors.

The conversion of an undervalued closed-end fund to the open-end variety creates the profits, according to Gordon's strategy. By definition, an open-end mutual fund trades at a price that reflects the market value of its holdings. So the price of an undervalued closed-end fund will rise if the fund is converted to an open-end fund.

Closed-end fund managers may oppose conversion for several reasons. First, they receive a management fee that is a percentage of total fund assets. After a fund is converted to open-end and the price rises, Herzfeld said, many fund investors typically sell, shrinking assets under management and management fees by one-third.

Fund managers may also oppose conversion because of a belief that an open-end structure--which requires them to redeem investor shares on demand in cash--will hurt the fund in the long run.

Criticism of Tactic

Nick Bratt, president of the Scudder New Asia Fund--mentioned as a possible target by Gordon--said that an open-end structure could hurt the fund in the long run by forcing it to raise cash by dumping stocks of small, growing companies at inopportune moments.

http://articles.latimes.com/1988-07-09/business/fi-5443_1_closed-end-fund

Tuesday November 6, 2012

Hostile takeover of iCapital.biz?

By RISEN JAYASEELAN
risen@thestar.com.my

PETALING JAYA: Closed-end fund iCapital.biz Bhd, managed by seasoned fund manager Tan Teng Boo, has become the target of opportunistic investors who may embark on a hostile takeover of the company, insiders close to the matter confirmed.

European hedge fund Laxey Partners has accumulated close to 10 million shares in iCapital.biz, representing just under a 6.9% stake. Laxey has a track record of targeting listed funds that trade below their net asset values (NAVs).

It is fairly common for institutional funds that have bought stocks of closed-end funds trading at a sharp discount to their NAVs to vote for their liquidation.

A request has been put forward to iCapital.biz to have one Andrew Pegge made a director of the company, along with two others Lo Kok Kee and Low Nyap Heng. Shareholders will vote on this at iCapital.biz's coming AGM this Saturday. As such, the AGM is being touted as a must attend for all shareholders who will no doubt be presented with arguments from both sides, namely the current management of iCapital.biz, headed by Tan and from parties associated with Laxey.

Pegge is the founder and a director of Laxey and has been embroiled in bitter shareholder disputes in the past. He has been described as a shareholder activist and manages funds that look to take advantage of “discount volatility” in investment trusts.

Together with Lo, they had embarked on a very similar move in Singapore last year, taking a position in SGX-listed closed-end fund United International Securities (UIS) and seeking board representation on the basis of championing a narrowing of the gap between the market price of UIS with that of its NAV. Laxey and Lo have also embarked on similar efforts in Malaysia in the past with Amanah Millenia Fund and Amanah Harta Tanah PNB2, respectively.

Another substantial shareholder has also emerged in iCapital.biz, in the form of London Investment Management Co Ltd, with a 6.5% stake. It isn't clear if this fund is in cohort with Laxey but they are both the largest shareholders in iCapital.biz, collectively owning at least 18.7 million shares (or 13.4%) out of the total 140 million iCapital.biz shares.

Although far from having a simple majority of iCapital.biz shares, this combined stake does wield some power considering that the remaining shareholders of iCapital.biz seem to be spread out.

According to iCapital.biz 2012 annual report, it has more than 3,000 shareholders. But about 65.8% of its shares are held by about 2,000 minorities who hold between 100-10,000 shares. Tan's Capital Dynamic Assets Management Sdn Bhd, which manages the closed end fund, has only 689,000 shares or a 0.49% stake.

Sources close to iCapital.biz said that Tan was very concerned about the moves to have new members on board and will consider stepping down if shareholders were to give in to the request.

In what is seen as a defensive mode, iCapital.biz has put up two individuals to be elected to the board, namely Datuk Tan Ang Meng, the former CEO of Fraser & Neave Holdings Bhd and Dr Yin Thing Pee, a medical specialist.

iCapital.biz shares have seen some active trading this week and hit a 52-week intra-day high of RM2.56 yesterday and then closing at RM2.49, up almost 9% from early last week.

iCapital.biz has had a decent performance since its listing in October 2005, with its NAV rising from 99 sen then to RM2.95 as at Oct 24. The performance of its share price has also outpaced the FBM KLCI. However, its stock has traded below its NAV, a gap which earlier this month stood at about 30%. The gap has since narrowed to around 19%.

iCapital.biz's ethos is to allow long-term shareholders to benefit from value investing and is helmed by the respected Tan, who is a sought-after commentator of economic and corporate affairs. Laxey though is likely to put forward a simple and pragmatic suggestion to iCapital.biz shareholders: liquidate your company and cash in at its NAV (or close to it).

http://biz.thestar.com.my/news/story.asp?file=/2012/11/6/business/12278095&sec=business

Using closed-ended funds

Closed-ended funds can be used

• to build out a portfolio or
• add specific components like international exposure.

Patient value investors seek not only a good price (meaning a good discount), but also a fund with solid long-term potential.

Many pros use closed-ended funds, including Warren Buffett.

• In 1972, Source Capital was trading at nearly a 50% discount to NAV. Buffett purchased almost 20% of the outstanding shares.
• Though the price fluctuated in the interim, Buffett hung in for 5 years before selling for an estimated $15.7 million profit.

http://myinvestingnotes.blogspot.com/2009/07/using-closed-ended-funds.html

Analyzing Retail Stocks - Economics of the business, and what it means for investors

In this post, the nature of retailing and the key factors that affect a retailer's health is described. It broadly forms the base of the investment thought process for investments in retailers.

The nature of the retail business

and the fundamental drivers of success

The retail business is a tough one, and very few retailers succeed in building enduring businesses. The retail landscape has changed tremendously over the last few decades. Fast food restaurants have replaced Automats, and big box retailers have risen to prominence at the expense of high-street/city center retailers. Retailers have to adapt to changes in fashion, lifestyles and consumers tastes. Large established retailers that fail to adapt can fall swiftly; witness how bellwethers like Sears, K-Mart and Circuit City have gone from boom to bust in a matter of years.

Retailers are fundamentally in the business of distribution. They create value by getting products to consumers, in a manner accessible to them when they need it. For a retailer to be successful, it needs to:

1. Stock products that customers intrinsically want.Retailers are rarely able to generate intrinsic demand for a product. The intrinsic demand for a product is determined by a combination of product marketing, consumer lifestyles and the prevailing zeitgeist. What retailers do is to meet that demand by making the products available to consumers. Retailer merchandising and presentation play an important role in stimulating the desire to purchase a product, but they only work if the customer has a fundamental need/demand for the product.For example, it's unlikely a retailer will succeed in selling chicken feed in New York city, no matter how creatively the product is merchandised. 

Retailers can either create their own items to stock (such as retailers like the Body Shop, or the general provisioners of the early 1900s who sold brand-less commodity items), or stock items made by other companies, as long the products are what people desire and fit into the position and mind share occupied by the retailer. FMCG companies add value for the retailer by supplying them with products that their customers want, at a lower cost and with less hassle than having to develop the products themselves. This symbiotry between FMCG companies and retailers has evolved over the years, since it started in the late 1800s when P&G, Colgate and other FMCG companies were founded.

Retailers need to adjust their merchandise mix over time as tastes and needs change over time. Products that are considered necessities today may become irrelevant in a decade, and products that people aspire to change over time. Many retailers fail because they do not keep up with lifestyle and zeitgeist changes.

2. Make it convenient for consumers to buy. Because people generally do not derive value from the buying process; they see it as something they have to go through to get to the value that products deliver (e.g. refreshment from a drink, the cleaning power of a soap, etc.). People tend to buy from the store that is the most convenient to buy from. 

What about people who enjoy shopping? While it's true that they derive value from the shopping activity, the actual purchasing process is not something they would place much value on. Their shopping expeditions will generally be to places which are convenient, being both accessible and a one-stop destination for the merchandise being sought. So making it convenient for consumers to buy is key to successful retailing. To do this, retailers must:

• (a) be accessible in the context of its customers' lifestyles. People will only visit stores that are conveniently accessible to them. The only exception is when a store sells something that a person has become addicted to or induces a strong physiological response, such as pornography and addictive items.
  
  For example, malls and big box stores fit the car-centric lifestyle of suburban shoppers in the U.S. Big box grocers find it harder to succeed in Japan because many people there do not drive, and also have small fridges which cannot store a week's worth of shopping. Instead, convenience stores scattered amidst the urban alleys are more suited to the Japanese lifestyle, because most Japanese consumers walk to subway stations on their way to and from work.
  
  The way people shop changes with changes in their lifestyle, which is typically driven by technological advances and changes in the zeitgeist. For example mail order used to be a convenient way to buy things, but is today rarely used as (1) people are more mobile and able to travel to stores easily, (2) modern logistics networks bring all kinds of goods to local stores, obviating the need to buy from a faraway mail-order retailer, and (3) the prevalence of Internet shopping, which has made mail order less relevant (though not extinct - for example, NBrown in the UK still runs a large home shopping operation)
• (b) be a one-stop shop for the position that it has carved out in people's minds. Each retailer has a position in the customer's mind (for example, a store to buy "natural remedies" or "imported groceries" or "stuff at bargain prices"), and the merchandise mix in the store must support that position. When a customer walks into a store, he/she should be able to find all the items that he/she is looking for. A successful shopping trip reinforces the retailer's position in the customer's mind, while a wasted shopping trip makes it more likely that he will choose another store in future. No amount of positioning marketing will help if the store doesn't have the range of goods a customer looks for.

The economics of the retail business
and sources of competitive advantage

The economics of the retail business are similar to that of the distribution business. Both are a combination of a logistics network and a trading business (inventory management). Like distributors, retailers are price-takers when there are multiple competitors serving the same target customers. On the other extreme, a dominant retailer in a town enjoys a natural moat that gives it pricing power. This does not mean that a retailer's pricing power grows with size, rather there is a tipping point between the two extremes.

• A retailer generally has no price-setting power when there is a competitor serving the same group of customers. (i.e. targeting the same customer profile, and present the same assortment of goods at the same locations/customer touch points). The economics of the distribution business are such that a customer faced with the choice of buying from 2 or more distributors will not be willing to pay much more for one distributor's services as opposed to another. Certainly some people may be willing to pay more to visit a cleaner/less crowded store, but the premium they are willing to pay is minimal. The players are price-takers, and the only sustainable competitive advantage is to be the lowest cost operator within its market. Having the lowest cost of operations and procurement allows the retailer to match all competitor price actions while remaining profitable.
• However a retailer has price-setting power if no other retailer is serving the same group of customers. For example, if a grocery store is the only one that is accessible to the residents of a town, then the retailer can generally set the prices for its services. Likewise, the only store to sell specialty cheeses in a city can set the price for its services.

Size is a source of competitive advantage. All things being equal, the economics of retail are such that the value that a retailer brings to customers increases naturally in proportion to the size of its operations. The largest retailer will almost by definition (a) be the most accessible to customers with the best network of sites by virtue of the in-place nature of the business, and (b) have the widest range of goods. The economies of scale that exist in distribution means that the largest distributor is also likely to have the lowest unit costs, and thus able to offer the lowest prices in order to fend off competitors who try to compete on price.

The largest enjoys a positive feedback loop where its increasing size improves its competitive position, which in turn increases it size, and so on. Once a dominant position is achieved, the economics of distribution gives the retailer a structural competitive advantage and makes it very difficult for smaller competitors in the same category to compete.

This doesn't mean that no other retailer competitor will survive, because consumers don't just base their buying decisions on these factors; there will be people who prefer the competitor's store because of its color scheme, etc. (This applies less to distributors who sell to businesses, because business buyers tend to make economical decisions. Take for example, the different buying behavior between consumers and fleet-buyers when they buy cars. The former will be influenced by styling, while the latter will be driven by fuel efficiency and maintenance costs.)

Building an enduring long-term retail business
with a sustainable competitive advantage

The economics of the business means an enduring retail business is one that is able deliver value to its customer and achieve and retain dominance. This means that an enduring retailer is one that is able to:

(1) Constantly adjust its inventory to continuing stocking products that its customers want, and adjusting its mindshare position in its customers' minds accordingly. (or it could try selling products that are relatively insulated from fashion trends and quick changes in demand)

(2) Constantly adjust it store accessibility, to be accessible even when its customer's lifestyles change. (or it could be serving a consumer group whose lifestyle that isn't expected to change much)

(3) Achieve the lowest cost of operations. In the retail business, this means:

• (a) Maximizing inventory turns. Moving inventory as quickly and efficiently as possible. Fast moving inventory also allows the retailer to reduce the capital intensity of the business, and increases the flexibility to quickly change stock when customer needs change. Conversely, slow moving inventory means that capital is tied up (and financing costs incurred), and also prevents the retailer from purchasing new stock to cater to seasonal or changing customer demands.
• (b) Maximizing sales per square foot. A higher sales intensity increases capital efficiency and productivity. Per unit operating costs are also reduced through the efficiencies gained from selling more in a single location.
• (c) Maximizing economies of scale. This is a business where there are economies of scale. A retailer that has higher purchasing volume will be able to extract more price concessions from its suppliers. Likewise, higher merchandise volume means that the retailers logistics and distribution infrastructure will be better utilized. For example, trucks will travel with full loads, and the fixed costs like warehouse management systems will be amortized a larger volume of merchandise.

Openings that an upstart competitor can exploit
to displace a dominant retailer

The competitive landscape of retail is like an open savannah, where the playing field is flat with few natural defensive positions. The factors of production, technology and merchandise used in retail are available to all competitors. Likewise consumers can switch retailers easily, and lifestyle and fashion changes affect all retailers. A competitive retail landscape is like a highly evolved Savannah ecosystem, where individual players have carved out their own survival space (value to customer, delivery model etc), and their incumbency is evidence of their competitive strength within a niche. In other words, they will likely have found the best way of utilizing existing factors production for a particular customer niche. The more competition the incumbents have defeated, the less likely it is that there are unexploited factors that the incumbent has overlooked.

In this landscape, competitors can establish a survival space only if one of the following openings exist:

(a) They ride a changing consumer wave or change in zeitgeist. In other words, exploit a changing customer profile which the incumbent isn't attuned to. For example, Sears used to be the dominant retailer in the United States, but the rise of suburbia, the auto-culture and changes in tastes allowed big-box stores and category killers to muscle in on Sears' dominance.

(b) They find some technology or operating technique which the incumbents have overlooked. This is difficult, but not impossible. Walmart did just that to K-mart, by exploiting the logistics efficiencies of building store in geographically contiguous fashion. It built out its network of stores in small towns by going into towns next to each other. This logistics efficiency allowed it to achieve lower costs that the incumbent discounter K-Mart, which had store that were situated in big cities hundreds of miles apart.

(c) The incumbent messes up. The dominant retailer may also mess up, for example, by allowing its store to be infested by rats. Dominant retailers can also the mistake of muddying its position and deviating from the formula that made it successful. For example, a retailer with the position of lowest-cost discounter may try to become an aspirational retailer that sells higher-end goods. Because of the Savannah like competitive landscape, deviating from a survival space means that a retailer is exposing itself to open competition from other players who have already found the competitive advantage in their survival space. The dominance in one survival space often does not translate to another survival space, and the retailer will be starting from zero in its competitor's stronghold. This doesn't mean that a grocery discounter will be unsuccessful selling discount electronics, because the competitive dynamics of both areas are similar. But a discount grocer trying to sell fashionable clothes is going to find it tough going, because the survival dynamics in each space are vastly different.

What this means for Investors
who invest in retail companies

Investing in retailers involves a quantitative assessment of the retailer's cost position and dominance, and a qualitative assessment of whether its position, customer base, and accessibility to its customers are likely to continue relative to zeitgeist and technological changes. It basically means:

1. identifying retailers that have established strong survival spaces, and
2. constantly monitoring the landscape for evidence of competitive openings that may have been created, and
3. constantly monitoring the changes in consumers' lifestyles and evidence that the retailer is keeping up with these changes

It is more than a simple spreadsheet exercise, unless we are planning to liquidate the retailer for its assets.

http://www.ventureoutlook.com/2009/07/investing-in-retail-stocks-business-and.html
SUNDAY, JULY 19, 2009

Aeon Credit: Managing Director's Operations Review

MANAGING DIRECTOR’S OPERATIONS REVIEW

Financial Review (FYE 20.2.2012)

AEON Credit Service (M) Berhad has recorded stronger annual business growth in the year ended 20 February 2012 compared to the previous year, from successful business strategies deployed under an environment of favourable market conditions.

Total revenue for the financial year of RM344.27 million represented growth of 27.7% from previous year revenue of RM269.61 million. This is attributable to growth in financing receivables achieved for credit card operations, product Easy Payment schemes and Personal Financing scheme during the year. Total transaction and financing volume of RM1.66 billion for the year represented growth of 40.9% from the previous year. Profit before tax (PBT) recorded for the year of RM128.06 million 50.6% higher than RM 85.02 million PBT in the previous year. 

The financing receivables as at end of FYE2012 was RM1.49 billion, representing growth of 34.5% from RM1.11 billion in the previous financial year. Meanwhile, non-performing loans (NPL) ratio was 1.80% as at February 2012 compared to 1.83% in February 2011, reflecting satisfactory asset quality management in spite of the sharp growth in business and receivables in the year.

Increase in annual operating costs in FYE 2012 by 17.3% is in tandem with business growth and lower than revenue growth of 27.7%. The Company was able to record improved margin of profit before tax against revenue for the year of 37.2% compared to 31.5% in the previous year due to improved cost efficiency from sharp growth in receivables in the year, lower ratio of net impairment loss charge for the financial year against total financing receivables and reduced overhead costs for depreciation and rental expenses. Average funding cost in February 2012 was lower marginally compared to February 2011 due to new funding at competitive rates in the year from various sources.

Other operating income recorded of RM24.90 million for the year was 44.4% higher than previous year. This is attributable to continued growth in fee income, especially from sales of insurance products, and increase in bad debts recovered.

Operational Review

Card Business

While 2011 was a challenging year for credit card issuers in Malaysia to increase their customer base, the Company’s  principal credit cards in circulation as at February 2012 had increased by 11.3% from the previous year based on database marketing efforts, various promotions carried out and enhancement of card benefits.  Total credit card transactions volume of RM716.61 million represents growth of 52.2% against the previous year, realised from both increase in card member base as well as higher average card usage amount.

Meanwhile, the company introduced “EPF kiosks” located at all branches and AEON shopping malls to attract increased walk-in consumer traffic and enhance opportunities for sales and cross selling of financial service products offered by the Company including credit cards and Personal Financing. The company will strive to convert more J-Card members  to AEON credit card members and enhance card benefits in collaboration with AEON Co. (M) Berhad to be a preferred credit card among its customers in FYE2013.

Easy Payment and Personal Financing Business

The Easy Payment and Personal Financing schemes saw a 33.3% annual growth in financing volume to RM940.12 million for the year under review. Database marketing activities and attractive financing rates during the year served to increase transaction volume significantly for personal financing operations, which registered 103.2% annual growth in receivables against the previous year.   

Further, the Company continued to obtain increasing volume of consumer credit applications from the growing base of merchants for the consumer durables and motorcycle financing operations during the year. The company continued to focus on growth in business for larger financing amounts from the middle income consumers, both for purchase of consumer goods and motor vehicles  as well as personal financing needs.

Future Plans

The Company anticipates to be able to sustain growth in its financial performance in the financial year ending 20 February 2013 based on its business strategies despite the lower economic growth rate forecast for 2012.

For the credit card operations, the Company intends to issue new cards targeted at the higher income group consumers in FYE2013 while strengthening card recruitment activities both at AEON shopping malls as well as through other marketing channels. 

Meanwhile, Easy Payment scheme operations will be expanded to provide equipment and other asset financing to small businesses . The Company shall expand the consumer durables financing scheme to offer financing for personal services utilised by consumers.  Financing for higher cubic capacity motorcycles and expansion of pre-owned  car financing will continue to be an area of focus as well as merchant network expansion. 

Additional branches and service centres shall be opened nationwide by the Company in FYE 2013, to facilitate greater market reach to consumers, especially for personal financing scheme operations and providing customer service.

Further, the Company shall pursue growth in fee revenue from services in FYE2013, including sale of insurance products, to complement income generation from receivables. The Company will focus on nationwide business expansion while taking necessary action towards sustainable business growth, maintaining prudent risk management policies and healthy asset quality.  

Acknowledgement

I would like to thank our customers, business partners and shareholders for your continued support and confidence in the Company. I would also like to express my sincere appreciation to the Board of Directors, management and staff of the Company for your contributions and dedication, which are essential for the future growth of the Company.

Yours sincerely,

Yasuhiro Kasai

Managing Director

http://announcements.bursamalaysia.com/EDMS/subweb.nsf/all/CCBFAB89E43259EA48257A0C0033D466/$File/AEONCR-AnnualReport2012%20(3.3MB).pdf

Annual Report 2012

Podcast: iCap Tan Teng Boo

26.7.2010
http://www.bfm.my/breakfast-grille-270710-tan-teng-boo.html?mobile=0

Buffett’s Watershed Investment - From Graham to Fisher: See’s Candies:

• Buffett was initially "not sold" on purchasing See's Candies when presented with the opportunity in 1971.
• See's Candies was offered for $30 million and it was hardly a Graham style investment. See's had only $5 million in tangible asset value at the time.
• Berkshire shareholders can probably credit Charlie Munger, Berkshire's Vice Chairman, for convincing Buffett to make this investment.
• Buffett eventually agreed to a $25 million purchase of See's and based the logic of the purchase on See's earnings power and brand equity.
• The valuation paid was approximately 11.4 times trailing earnings.
• Buffett believed that See's had significant additional pricing power that was not being leveraged and could sell for premium prices compared to other candies.

This was what Buffett had to say about See’s Candies in his 2007 annual letter to shareholders:

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.

Lessons learned:

1.  Clearly See’s Candies is a business that is today worth many times the amount paid to acquire the company in 1971.
2.  It is not a business that requires a high level of invested capital.  
3.  The value of See’s is the earnings power of the business.
4.  That earnings power of See does not come from tangible equity.  It comes from intangible assets, and specifically from the brand equity of the business.



Comparing Benjamin Graham and Philip Fisher's Techniques

Practical Application of Fisher’s Techniques
What can value investors take away from Philip Fisher’s book and from Warren Buffett’s application of these concepts?  

The evidence is overwhelming that buying a business like See’s is far more attractive than buying “cigar butt” investments that are quantitatively cheap but either dying or offering average prospects for the future.  

However, the big caveat is that any investor seeking the higher payoffs accruing to intangible assets like brand power must be very sure in his analysis to avoid buying into the sort of promotional stocks that Fisher warned us to avoid. 

In short, knowing your “circle of competence” is critical to avoid paying up for illusory growth and taking the risk of permanent loss of capital. 

Losing capital permanently is much less likely with Graham’s quantitative approach, but that approach also entails higher turnover and lower potential returns compared to a successful application of Fisher’s techniques.


Read:
Roger Lowenstein’s excellent 1995 biography of Warren Buffett, The Making of an American Capitalist, the purchase of See’s in 1971.
Alice Schroeder’s recent Buffett biography, The Snowball,

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