Shift to Quality

Graham was too focused on price at the expense of quality.  Of course, this is an oversimplification.   Graham also took account of other factors, such as growth or stable results, although he didn't put as much emphasis on them.  

Most investors today pay attention to other drivers, such as growth or business quality, assigning increasing weight to them over time.



Philip Fisher

Philip Fisher played a pivotal role in the transformation undergone by many investors.  It was under the influence of his partner, Charlie Munger, that Buffett first became attracted to Fisher's philosophy.

Fisher put his money on investing in long-term growth stocks, with very robust competitive advantages that were capable of being sustained and increased over time.  The price paid for them was not as important, since if the company performed well it would be able to sustain a high multiple.  

This idea is less intuitive and therefore harder to digest than simply buying something cheap; it means paying seemingly expensive prices for something that will only yield results after a period of time.

This is ultimately the road that Buffett has gone down.  Thus, most value investors are also indirectly indebted to Fisher to some degree or another.

For those who have maintained a certain unshakeable bias towards investing in cheap assets, whose quality was not always proven, it can be a challenge to change their ways, especially when this mix had produced good results.

Every investor develops at their own pace.  



Joel Greenblatt

Joel Greenblatt's short book, The Little Book That Beats the Market, gives empirical proof that quality shares bought at a good price will always outperform other stocks.  

To do so, he classifies each stock according to two criteria: 

• quality, measured by ROCE (return on capital employed) and 
• price, measured by the inverse P/E ratio (price to earnings, the price that we pay for each unit of earnings).  [You can also use FCF yield, that is, FCF/price, instead of inverse P/E].

Greenblatt uses a numerical classification for both return and price:  1, 2, 3,4,...., with 1 being the stock with the highest ROCE under the return criteria and 1 being the highest free cash flow under the price criteria.   He then adds the points obtained by each share in both rankings to produce a definitive classification, which he calls the 'magic formula'.  

• The companies with the lowest sum of both factors deliver the best long-term returns.  
• Furthermore, the same is true throughout the ranking; companies situated in the lowest 10% post a better return than the second 10%, the second decile outperforms the third, and so on until the last 10%.

The exceptional results obtained by Greenblatt is surprising, but logical:  good companies bought at reasonable prices should obtain better returns on the markets.

The problem with applying this approach is that the formulas deliver over the long term, but they can also underperform for relatively long periods, for example, three years  this makes it though for both professional and enthusiast investors to keep faith when things are not working.

The disconnect between economic and earnings growth

Saturday, 21 Sep 2019

By Pankaj C. Kumar

THERE has been much debate about the lacklustre performance of Malaysia’s stock market vis-à-vis other regional or North Asian markets. There are many factors that determine a market’s performance and one of the reasons is due to the poor earnings in corporate Malaysia.

However, the other side of the argument is that, why aren’t our corporates doing well and showing earnings growth as we have been having relatively stable economic growth for years now?

Indeed, this is true. But to answer this perpetual question, one needs to understand how gross domestic product (GDP) is measured while at the other end, how are earnings derived. Is the comparison between GDP and earnings growth relevant and should they be correlated?

GDP can be measured on three counts namely by expenditure, output or factor income, and all three measurements provide the same sum of value. We typically explain GDP by expenditure and output or also known as aggregate demand and aggregate supply respectively.

Measurement of GDP by factor income is not a common practice in Malaysia. GDP measured by factor income takes into consideration income (i.e. wages and salaries); profits of businesses and the third component is rental income from ownership of land.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284546.JPG

GDP measured by expenditure or aggregate demand comprises both the public and private consumption and investment, change in value of stock and net exports. GDP measured by output or aggregate supply is measured using the output of the various economic sectors and this of course includes the services sector, the manufacturing sector, mining, agriculture and the construction sector.

In essence, GDP measures the total output generated from the economy, i.e. both the value of goods and services produced and by default, it is the measure of the size of the economy. How big is a nation’s economy in terms of the value it creates every year? When we say the economy expanded by 5%, it means the output value of both goods and services grew by 5% compared with the previous year. GDP is also measured on two counts.

One is GDP in nominal terms and the other is GDP in real terms. Of course, the difference between the two is the rate of inflation and typically GDP in real terms grows slower than GDP in nominal terms which is measured based on current values. In other words, GDP in real terms only takes into account growth of the economy while GDP in nominal terms takes into consideration not only the growth factor but the price factor as well.

GDP is also measured based on a certain base year. Today, Malaysia’s economy is measured based on the 2015 base year (from 2010 base year previously), to reflect the nation’s current economic dynamics. To get a real GDP data, the nominal GDP is adjusted by a factor called “deflator”. A deflator is a measure of inflation from the current base year of 2015. Chart 1 shows Malaysia’s GDP between 2015 and 2018. From here, we could also make a summary that deflator used for the year 2016,2017 and 2018 are 1.0166,1.0552 and 1.0627 respectively.

Earnings on the other hand, is only measured based on current prices as our accounting rules do not take into consideration inflation neither is it re-based every five years. Earnings is also a measure of profit and not revenue. Typically, for GDP, the output measure is actually revenue to the provider of goods and services and not profit. Of course, one can argue that if revenue is rising, which typically does, should it not reflect in better earnings? The straight answer, yes definitely. But, bear in mind, net profit is not cashflow and earnings are also adjusted for various accounting rules as well as non-cash items like depreciation, and amortization. So to compare GDP to earnings performance is not exactly accurate either. In addition, as defined as to what GDP actually measures, it is difficult to correlate what is spent from aggregate demand of the economy to the aggregate supply as some of this demand and supply is not captured among listed companies. Hence, there is indeed a mismatch between GDP and even revenue of our corporates.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

For example, the public sector accounts for almost 20% of aggregate demand while private sector accounts for 74% of the annual GDP. On the supply side, services sector is about 57% of the economy while manufacturing sector is at about 22%. Mining, agriculture and construction makes up the balance 20%. While some of this output of goods and services is carried out by listed companies, there is a significant amount that is not represented in the market. This include large MNCs which are not listed, SMEs, which are backbone of the economy, as well as smallholders in the agriculture sector while Malaysia’s No.1 corporate, Petronas, the parent company, too is not listed. Some of the output generated from these industries or by our national oil corporation is for exports and not all our exporters are listed either.

With this, we can now see that earnings are NOT correlated to the GDP and hence poor earnings growth over the last few years had little to do with economic growth. Based on Bank Negara’s statistics as per Table 1, we can deduce the market EPS at the end of each year by taking the KLCI index level divided by the market PER at the end of each period. The EPS growth can than be calculated from these figures and we can now see the correlation between Nominal GDP growth and EPS growth as shown in Chart 2.

The chart basically shows that since the re-basing of the GDP, Malaysia’s nominal GDP expanded steadily in 2016 and 2017 but fell back in 2018. Earnings on the other hand was negative in 2015, marginally positive in 2016 and 2017 but was extremely poor in 2018.

As the 1H reporting season has just ended, we have observed that based on data compiled by research houses, market earnings have contracted by 8.2% year-on-year and the current market estimate is that earnings for 2019 will be negative 1.8%. For this to materialise, corporate Malaysia’s 2H earnings has to be a strong 4.6% y-o-y growth to enable the annual earnings growth to hit the expected contraction rate of 1.8%. As inflation is probably to average about 1% this year, the 2019 nominal GDP growth too will likely mirror that of 2018 performance, i.e. at about 5.5% growth. Hence, while the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, well, at least for 2019.

image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284582.JPG

In addition, if we look at the composition of our 30-stock FBM KLCI, the index itself is heavily weighted towards the banking sector, which makes-up about 36% of the index, while Tenaga Nasional and the telco sector are the next heavyweights, accounting for about 21% of the index itself. Hence, with the banking sector not particularly performing well, especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.

The failed merger between Axiata-Digi too has now taken its toll on the index while the gaming sector (the likes of Genting and Genting Malaysia), plantation and rubber glove makers have their own issues related to governance, poor corporate results brought about by weaker commodity prices as well as stretched valuations. Hence, the poor performance of the FBM KLCI year-to-date is understandable and it is not due to the weakness or strength of the Malaysian economy but more of whether the index itself is reflective of the economy as whole or otherwise. In fact, seven companies alone represent about half the FBM KLCI weight and they are Public Bank, Tenaga Nasional, Maybank, CIMB, DiGi, Maxis and Axiata, and their market performance alone can dictate the FBM KLCI’s direction.

The views expressed here are the writer’s own.

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image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

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image: https://apicms.thestar.com.my/uploads/images/2019/09/21/284583.JPG

Read more at https://www.thestar.com.my/business/business-news/2019/09/21/the-disconnect-between-economic-and-earnings-growth#9lGpHfbTTsxgsmQC.99




Summary:

GDP can be measured in 3 ways:  expenditure, output or factor income.

Aggregate demand:  
Public sector accounts for 20% 
Private sector accounts for 74% of the annual GDP.

Supply side: 
Service sector: 57%
Manufacturing sector 22%
Mining, agriculture and construction 20% of the annual GDP

Output of goods and services not represented in the market:
Large MNCs which are not listed
SMEs (backbone of the economy)
Smallholders in the agriculture sector
Petronas, the parent company (Malaysia's No 1 corporate)



1H reporting season (data by research houses)
Market earnings have contracted by 8.2% year-on-year
Current market estimate is earnings for 2019 will be negative 1.8%.

Earnings is a measure of profit and not revenue.  GDP, the output measure is actually revenue to the provider of goods and services and not profit.  So to compare GDP to earnings performance is not exactly accurate either.  

Some of the aggregate supply and the aggregate demand are not captured among listed companies; hence, there is indeed a mismatch between GDP and even revenue of our corporates.

The 2019 nominal GDP growth will likely be about 5.5% growth.

While the economy remains on an expansionary mode, the earnings of corporate Malaysia is hardly a reflection of the strength of the economy as it is likely to remain in the doldrum, at least for 2019.



30-stock FBM KLCI weightage

Banking sector 36% of the index
Tenaga Nasional and the telco sector  21% of the index

Banking sector not performing well especially with the environment where net interest margins are thinning and loan loss provisions are under pressure, the sector itself is a drag on the FBM KLCI.

Other issues contributing to the poor performance of the FBM KLCI:
Failed Axiata-Digi merger
Gaming sector (Genting and GENM)
Plantation & Rubber glove makers (Corporate governance issues, poor corporate results due to weaker commodity prices as well as stretched valuations).

The index is not reflective of the economy as a whole.  Seven companies alone represent about half of FBM KLCI weight and their market performance alone can dictate the FBM KLCI direction:
Public Bank
Tenaga
Maybank
CIMB
DIGI
Maxis
and Axiata

Impairment charge

"Impairment charge" is the term for writing off worthless goodwill.

These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs.

Impairment charges will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets.

Accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the mis-allocation of assets that occurred during the exuberant business period. In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.

Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:

1. Company made large acquisitions.
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly.

The Quality of Companies: Practically all the value investors have gone down the same path of Buffett.

Graham was too focused on price at the expense of quality.  

However, in hindsight, it was clear that the portfolio of quality companies is the best approach to stand up to any market situations.

Indeed, past financial crises confirmed that high-quality companies at reasonable prices perform better over the long term than companies which are straight cheap.

Buffett invested in very underpriced real assets in the beginning of his investing career.   After partnering Charlie Munger, he focused on higher-quality stock, proxied by the degree of competitive advantage they enjoy.

Many investors have gone down this same path of Buffett, practically all the value investors.  The main reason is that it delivers better results over the long term, although there aren't many studies to back up this assertion, making it initially a far from obvious conclusion.



Why have practically all value investors followed Buffett, preferring quality companies?

Maybe, when they are young and start out investing, they have an excessive desire to do well and make their mark.  They tend to favour the cheapest companies, which on face value offer the greatest potential upside.

With experience and maturity, and after having stepped on a few booby and / or value traps (cheap companies in bad businesses, which languish for years, failing to create value) and their economic situation improves, their tastes tend to shift towards quality, even if they have to pay a bit more for it.

The company's growth plans: Your approach as an investor.

Good growth is exciting for any company that you own.

Growth can be through organic growth or through mergers and acquisitions.

However, as an investor, you should assign little importance to growth plans of the company in your investing decision.

It is far more important the company sets out the right strategy, since growth will follow in due course.

Many short-term growth targets get in the way of taking the right long-term decisions.

As an investor, you should be willing to ride out patchy results, considering this to be part and parcel of business.

On mergers and acquisitions, the investors should have a very clear stance: it is important to avoid the urge to grow for growth's sake; the focus should be on acquisitions that make sense and not overpaying.  It is important to avoid watering down a quality business with inferior acquisitions.

Business Quality

Business quality is defined by the return on capital employed, calculated before goodwill.

The implication is that better returns are synonymous with a better-quality business.

What is investing? My core.

Investing is all about buying a flow of earnings at an acceptable price.

The pace of earnings growth is a second-order issue.

Risk is the possible loss of long-term purchasing power.

Volatility of price is not risk.  It is the ally of the long-term investor.

The market is NOT ALWAYS efficient.  In general it is efficient, but NOT ALWAYS, and this small difference is crucial, enabling us to capitalise on it.

How do you select your stocks: Quality First, then Value.

A great company deserves a higher valuation. It is possible that you paid a slightly higher price than you wanted to pay for the stock, which lowers your overall rate of return, but time is on your side and your long holding time minimizes the impact of the higher purchase price to your overall return. Also, you will always find the opportunity to add to your position at lower valuations, though not necessarily at lower prices.


Deep value investing investors need to be cautious and aware of this approach's inherent problems. Those companies dropping and appearing in the deep-bargain screen probably deserved to be traded by low valuations. Their stock prices were likely low for the right reasons, and buying these would likely have resulted in steep losses.


How do you select your stocks: Quality First, then Value.

There are many gruesome companies in the stock market. These companies operate in very competitive environments and have to be managed well to deliver good returns. In the business world, it is often the economics of the business that eventually triumph over the skills of the managers, however superb their skills maybe.

A company that performed well for 3 years and then lose its good performance subsequently is not a great company, by definition. A great company is one that can perform well, consistently and growing its earnings over 20 to 30 years.

Not uncommonly, these gruesome companies trade at below their net tangible asset prices. This is to be expected, especially if their businesses continue to be gruesome. Their low trading prices attract some investors who are enticed by the very low price relative to their net asset value.

Here is a very important point for any investor. When the price of a company falls, all its valuation ratios become very good. Its price to book value, its price to sales and its price to earnings ratios, all fall and its dividend yield (using last year's dividends) rises.

The uninitiated may think these companies are now undervalued using these financial ratios. Here lies the risk of searching for undervalued stocks in gruesome companies.

The more intelligent investors do not solely rely on these financial ratios alone, they require a lot more analysis. As a general rule, most shares are priced appropriately most of the time. It is only some of the time, when they are mis-priced too low or too high.

The risk in buying great companies is overpaying too much to own it. However, great companies do have earning power for many years, by definition. They continue to grow their intrinsic value over time. If you can acquire these companies at bargain prices (very rarely) or at fair prices (commonly), you should do well in your long term investing. Also, it is alright to pay a little bit more to own these companies as over the long time of holding them, they will still reward you handsomely. As these great companies are few, selling them only make a lot of sense if you can find another of equal quality (very difficult indeed) that offers higher reward to downside risk with high degree of probability. Well, not unexpected, this is not easy.

Buffett says: Buying a wonderful company at a fair price is better than buying a fair company at a wonderful price. He is absolutely right. Stay with quality first, then value; and your investing over the long term should be quite safe and mistakes, if any, will be few.

Pentamaster

Pentamaster locks in RM238mil sales


Monday, 02 Sep 2019

By DAVID TAN




Pentamaster executive chairman C.B. Chuah checking out test equipment produced for the automotive and semiconductor industries


GEORGE TOWN: Semiconductor automated test equipment maker Pentamaster Corp Bhd
has locked in sales of RM238mil for the third and fourth quarters of 2019, which will boost its growth by double-digit percentage over 2018.

Group chairman CB Chuah (pic) told StarBiz that

• about 50% of the sales came from the smartphone segment, 
• while the remainder were from the automotive, factory automation and medical device industries.

The average pricing of each test equipment starts from US$500,000 onwards.

“This year, the demand for smartphones has contracted. Its contribution to group revenue is expected to shrink to about 55% from 70% previously.


“The electric vehicle (EV) and factory automation solution segments are growing, ” Chuah said.

The EV segment, for example, is expected to contribute 15% this year compared to 10% a year ago. “We expect the EV segment to generate about 25% of group revenue by 2021, ” he added.

The group is now in talks with a few EV customers interested to purchase testers from Pentamaster to test the power converters used in EVs.

“These customers are from Europe, China and the United States, ” he said.

Chuah said the group would allocate more financial resources to expand its EV business segment. “We see huge potential in the EV business. During the first six months of the year, the global sales of pure EVs increased by 92% to 765,000 units, according to Jato, a leading provider of automotive market intelligence.

“This total is the volume sold in 41 markets around the world.

“China’s commitment to electrification and Tesla’s sales growth were the main factors driving the growth in the first half of 2019, ” he added.

On the smartphone market, this is the worst slowdown in three years, according to Chuah.

“New smartphones are not equipped with fresh and innovative features, which is why sales have slowed.  Due to economic uncertainties, consumers are also not changing their phones.We expect to see a recovery in 2020, ” Chuah said.

According to the Connecticut-based Gartner Inc research house, worldwide sales of smartphones to end-users will total 1.5 billion units in 2019, a 2.5% decline year-on- year.

“Gartner analysts expect smartphone sales to grow again in 2020, driven by the broader availability of 5G models and the promotion of 5G service packages in various parts of the world by communications service providers. Analysts also expect the first 5G Apple iPhone to launch in 2020, which should entice iPhone users to upgrade, ” Gartner said.


Read more at https://www.thestar.com.my/business/business-news/2019/09/02/pentamaster-locks-in-rm238mil-sales#IwK0dJ6W85GtZ6kb.99

Value Added Statement

VALUE ADDED STATEMENT

Value added is an effective means of both measuring company performance and identifying the way in which the various interest groups involved share in the resources generated.

It is easy to develop one based on the income statement.

Value added is the difference between sales revenue and the amounts paid to external suppliers of goods and services.

SALES REVENUE – PURCHASES AND SERVICES = VALUE ADDED

S – B  =  W + I + Dd + T + Dp + R

S = sales revenue

B = bought in materials and services

W = wages

I = interest

Dd = dividends

T = tax            

Dp = depreciation

R = retained earnings

If sales revenue is expressed as 100%, the proportion of revenue being allotted to each interest group can be shown:

Sales revenue        100

Supplies      50

Employees  20

Interest          5

Tax                5

Shareholders 5

Subtotal                   85

Retained profit        15

Presenting income and expenditure in this way is popular with many companies.  The value added statement has proved to be a useful and practical means of communicating financial information to employees who find the annual report somewhat impenetrable.

A value-added statement can be displayed as a bar char to pie chart.  A pie-chart can effectively represent $1 and show how each unit of income or sales revenue received by the company in the year was shared out:  how much went to suppliers, employees, shareholders and government, and how much was left as retained profit for reinvestment into the business at the end of the year.

DISPENSING WITH PROFIT

Indeed, the word “profit” need not appear in a value-added statement.  What is left after all interest groups have received their share of the value added (the retained profit of $15) may be referred to as “amount retained for investment.”

If a value-added statement is prepared for a number of companies operating in the same business sector, it may be used for comparison and the development of benchmarks.

Value Added: Market Value Added and Economic Value Added

VALUE ADDED

• MARKET VALUE ADDED
• ECONOMIC VALUE ADDED

MARKET VALUE ADDED (MVA)

Market value added (MVA) 

= Current market value or capitalisation (to which debt may be added) – Total shareholders’ equity  

Example:

Capitalisation of a company is $100

Shareholders’ equity in balance sheet is $50

For every $1 of shareholders’ equity, the company has added $1.

ECONOMIC VALUE ADDED (EVA)

Companies should be expected to produce not only an accounting profit but also one that more than covers their cost of capital.

It is argued that EVA is better than earnings per share or price/earnings ratios as these do not take account of the real cost of capital.

Example:

After the charge of $10 ($100 x 10%) representing the estimated cost of capital, the company shows an EVA of $30 for the period.

After tax profit $40

Capital Employed $100

Cost of Capital 10%

After tax profit $40

Cost of Capital $10

ECONOMIC VALUE ADDED $30

A positive EVA indicates that a company is providing investors with added value.

A company with a consistent EVA should have an increasing MVA; it will be generating a rate of return above the cost of capital so the share price should rise.

Examples:

These three companies are all generating a positive return on capital employed.

Company A

After-tax profit $50

Capital employed $200

Cost of capital (10%) $20

ROCE (%)  25

EVA ($)  $30

Company B

After-tax profit $60

Capital employed $400

Cost of capital (10%) $40

ROCE (%)  15

EVA ($)  $20

Company C

After-tax profit $50

Capital employed $600

Cost of capital (10%) $60

ROCE (%)  8

EVA ($)  -10

Although company C produces a positive 8% return on capital employed, it is actually destroying shareholder value with a negative $10 EVA.

In practice, the calculation of EVA requires several adjustments – to allow for the treatment of R&D, goodwill, and brand values, leases and depreciation – to be made to the after-tax profit figure.

It is claimed that EVA, as a single monetary figure, is better at concentrating management attention on the “real” results of running the business than are standard performance ratios such as ROTA.

EVA is often used as a basis for managers’ performance-related incentives.

Growth is often seen as the best measure of corporate success.

Growth is often seen as the best measure of corporate success.

A company growing at a rate of 15% per year is doubling in size every five years.

Rapid-growth companies can be defined as those with annual growth rates of 20% or more.

Super-growth companies show a compound growth rate of around 40% per year.

MARKET SHARE INFORMATION

Market share information can provide valuable support to the analysis and interpretation of changes in a company’s turnover.

The majority of companies provide turnover growth details in their annual report, but few offer any details of market share.

When turnover is known for several firms competing in the same market, it is possible to devise a simple alternative to market share information.

Company	A	A	B	B	C	C	D	D	TOTAL	TOTAL
Year	1	2	1	2	1	2	1	2	1	2
Sales ($bn)	2.5	2.9	16	16.3	5.9	5.5	17.2	18.8	41.6	43.5
Share (%)	6	7	39	37	14	13	41	43	100	100

How their share of the joint total market changes can readily be followed.  If this is done for a number of years, the analysis can form the basis for a performance comparison.

RAPID GROWTH COMPANY IS NOT ALWAYS A SAFE AND SOUND INVESTMENT.  RAPID GROWTH CANNOT ALWAYS BE SUSTAINED. 

A common view is that a rapid-growth company is safe and sound investment.

However evidence suggests that rapid growth cannot always be sustained.  There are of course exceptions.  

BE CAUTIOUS OF GROWTH THROUGH DIVERSIFICATION OR ACQUISITION, THROUGH INCREASING DEBT FINANCING AND THROUGH TURNOVER GROWTH WITHOUT PROFIT.

·         However, it is probably safer to assume that rapid growth, particularly if associated with diversification, often through acquisitions, will not continue.

·         If high compound growth rates are matched by increasing debt financing, extreme caution is called for.

·         For some companies, turnover growth is seen as the prime objective and measure of success, even when it is being achieved at the cost of profitability.  In the late 1990s, e-business provided many extreme examples of this.

ONE-PERSON COMPANY

• GROWTH THROUGH DIVERSIFICATION, COMMONLY THROUGH ACQUISITION.

Being pushed towards diversification to fuel continued growth is often the final challenge for the one-person company.  Having proved itself in one business sector it moves into new areas, commonly through acquisition.  More often than not its old skills prove not to be appropriate in the new business, attention is distracted from the core business, and it is viewed as having lost the golden touch.  Its survival may depend on new management and financial restructuring.

• WHEN A ONE-PERSON COMPANY’S GROWTH SLOWS AND CRITICISM MOUNTS

When a one-person company’s growth slows and criticism mounts, two scenarios may occur. 

• ·         In one, the individual running the company begins to take increasingly risky decisions in the hope to returning to previous levels of profit growth. 
• ·         In the other, recognising that there is little that can be done immediately to improve operating performance, the individual steps outside the law and accepted business practice to sustain his or her personal image and lifestyle.  Often in these companies other executives are reluctant to rock the boat and go along with the deception.

Free Cash Flow

FREE CASH FLOW

An important factor in Shareholder Value Added analysis is the free cash flow (FCF) generating capability of a company.

This is the cash flow available after allowing for capital maintenance and interest payments.  FCF is calculated as:

Operating profit

Plus depreciation

Less cash tax paid

= Cash profits

Less investment in non-current assets and investment in working capital

= Free Cash Flow

FCF is useful in providing an indication of the level of a company’s cash flow generation.  

It also measures the amount of cash potentially available to cover the financing costs of the business after all necessary investment has been made.  Can the company safely consider raising more finance or making a major capital investment?

Companies often provide figures for their FCF, but there is no standard definition of the term so be cautious in using them.

If all interest payments are deducted, the resultant “levered free cash flow” indicates the amount of cash potentially available for dividends and future growth.

It is useful to compare the growth in free cash flow with that of earnings.  If the trends are significantly different, is it possible to find the reason?

RISK DISCLOSURE

RISK DISCLOSURE

Risk relates to future events that are quantifiable.

Uncertainties are future events that are indeterminate and non-quantifiable.  

In the 1990s, companies began to move from simple risk analysis to more proactive risk management.

Companies should disclose their risk management practices.

IFRS 7 deals with the risks associated with financial instruments.

There should also be discussion of the major risks and uncertainties facing the company and how these are being dealt with.  

The main classes of risk are identified as:

• -          Market risk:  exchange rate, interest rate or other price movements;
• -          Liquidity risk:  possible problems in making cash available.
• -          Credit risk:  customers fail to pay.

If there is an existing or potential liability, this is fully disclosed in the annual report as you need to know about this in order to properly assess the company.

RISK FACTORS

The risk factors are normally listed in order of significance.  

These provide some insight into management’s view of the risks seen to be facing the business.  

These may be related to a country’s economy, or a company’s industry or geographic location.  

Market risk includes interest rates, foreign exchange and commodity price risk.

“New” measure of risk.

An alternative approach to company risk assessment has been offered,  It is suggested that the number of times the word “new” appears in the annual report may provide a measure of risk.

Future Profit overrides Current Liquidity. Success or failure?

Ideally, a company can be expected to focus on 2 principal objectives:

1.  Future Profit:  To provide an acceptable and continuing rate of return to investors.
2.  Current Liquidity:  To maintain an adequate level of financial resources to support current and planned future operations and growth.



Future Profit and Current Liquidity

A company can survive without profit as long as it has access to cash.

A profitable company with no cash faces difficulties.

No company can survive for more than a few days with neither profit nor cash.



Future Profit overrides Current Liquidity

A profitable company is less likely to fail than an unprofitable one.

The overriding factor in deciding whether to allow a company to continue in business is its profit potential, which is more important than its current liquidity.

A company with low liquidity and a high profit potential will almost certainly be helped to overcome what may be regarded as a temporary problem.  

A highly liquid company with declining or no profit potential is unlikely to survive for long.   Why should investors leave their funds to dwindle?   The only decision facing such a company is 

• whether to end operations  immediately or 
• to continue and see liquidity and profitability decline until matters are taken out of management's hands.