Upward trend intact, stock picking is key

KLCI Valuation

Support from strong growth outlook and positive market drivers

Longer term uptrend intact. The KLCI is now trading at 15 times 2010 earnings (above its post-crisis average of 14 times) and 1.8 times book value (above its post-crisis average of 1.7 times).

Following strong GDP growth in the last two quarters, we upgraded our projected GDP growth to 5% for 2010, a turnaround from -2.4% in 2009.  Corporate earnings in the last two quarters have been upgraded by 6.7% for 2009 and 11.9% for 2010.

With that, we expect 2010 earnings to exceed pre-crisis levels.  On the back of strong growth outlook and positive market drivers, the longer-term upward trend is intact.  And riding on strong liquidity, multiples could be higher over the longer term.

Our end-2010 KLCI target of 1,448 is based on higher 16 times 2011 earnings, achieved in the 2007 upswing.  KLCI's valuations remain higher compared to regional markets.  This could result in Malaysia lagging regional markets.  This could result in Malaysia lagging regional markets in an upswing.

That said, the stellar 50% gain from the March low is likely to result in intermittent profit-taking.  In 1998 and 2001, the market rebounded by 26% - 136% over five months.

After the initial rebound, the KLCI corrected 15% - 20% over two months in both cases.  In this recovery, the KLCI is up 50% from March, and the sharpest correction since was only a 6% drop.  In 1998 and 2001, the market went on to reach new record highs, post-correction.

Ref:  HwangDBS Vickers Research

Effect of possible Ringgit appreciation

By end-2010, we expect the ringgit to appreciate about 5% against the US dollar (to RM 3.24/USD). 

Beneficiaries will include:

• aviation (MAS, Air Asia) and
• the steel sector (Southern Steel, Kinsteel),

where there is a high proportion of USD-denominated costs.

Losers will include:

• exporters (Evergreen Fibreboard) and
• MISC.

Rubber glove manufacturers (Top Glove, Kossan) price their products in USD.  However, we understand glove players usually adjust prices to factor in currency movements. 

The prospect of an appreciating ringgit could further boost returns for foreign investors.


Ref:  HwangDBS Vickers Research

Low Foreign Ownership in Malaysian Stock Market

Foreign investors were conspicuosly absent from the scene whenthe Malaysian stock market jumped 50% between mid-March 2009 and now.

This was evident in the insignificant level of trading activity by foreign investors (just 25% of trading value in Jan-Sept 2009) and the persistent net portfolio investment quarterly outflows (since 3Q07) with foreign ownership standing at a five-year low.

That may soon change.  Among the speculated reasons are:

• Coming off from a depleted base, foreign funds could trickle back into Malaysia, especially if global equities turn increasingly volatile ahead. 
• As the risk-reward profile tilts in the opposite direction because of stretched valuations, strategiests may be tempted to make a gradual tactical switch to more defensive low-beta markets like Malaysia.
• The prospect of an appreciating rinngit is an added appeal for investors in search of incremental investmen returns.

 Some under-owned stocks - with foreign shareholdings far below their recent peaks - that could increasingly come under the investment radar of foreign investors again are:

• CIMB (33% foreign shareholding in June 09),
• IJM Corp (34%),
• MRCB (19%),
• SP Setia (28%) and
• Tenaga (11%)

Ref:  HwangDBS Vickers Research

Best Performers in the KLCI

From March 09 low (%)

Genting 122
AMMB 111
CIMB Group 107
Axiata Group 86
Maybank 86
Astro 84
MMC Corp 79
PPB Group 70
Public Bank 58
KL Kepong 57
Hong Leong Bank 56
Parkson Holdings 53
IOI Corp 50
RHB Capital 48
KLCI 50


From 4Q09 (%)

Hong Leong Bank 24
AMMB 16
CIMB Group 15
KL Kepong 13
Tanjong 10
Public Bank 7
Sime Darby 7
IOI Corp 4
Tenaga Nasional 4
PPB Group 4
RHB Capital 3
Genting 3
Digi.com 3
MAS 2
Parkson Holdings 2
KLCI 5


Biggest contributors to the KLCI's gain from March 2009 low


39% Banks
25% Plantation
10% Gaming
8% Telco
7% Power
7% Others

Source: DBS Vickers, Bloomberg

More gloves shipped at higher average selling prices

Supermax says glove demand strong, profit up
Written by Reuters
Thursday, 07 January 2010 20:34

KUALA LUMPUR: Malaysia's No 2 rubber glove maker Supermax expects another year of strong profit growth as fears about a resurgence of the H1N1 flu fuel demand for its products, a top executive told Reuters today.

Supermax may upgrade its earnings target for 2010 when it announces its full-year earnings for 2009 in February, managing director Datuk Seri Stanley Thai said.

The glove maker had previously guided for a net profit of RM133 million for 2010.

"2010 will continue to be a good year for the glove industry. We expect handsome profits," Thai said in a telephone interview.

Supermax has already received glove orders that will keep its factories busy for the next four to five months, he said.

Thai also said fourth-quarter net profit will be better than the third-quarter.

"We shipped more gloves at higher average selling prices in the fourth-quarter than the third-quarter," he said. — Reuters

Focus on the companies with Economic Moats

Economic moats are long-term competitive advantages that allow companies to earn oversized profits over time.  These are the companies you should focus your attention on.

There are 4 main types of economic moats:

• Low-cost producer or Economies of Scale
• High switching costs
• Network effect
• Intangible assets

The more types of economic moats a company has, the better.

The longer a firm can sustain its competitive advantage, the wider its economic moat.


The Bottom Line

• While having these four types of of moats, or competitive advantages, as guidelines is helpful, there is still a lot of art to determining whether a firm has a moat. 
• At the heart of it, the harder it is for a firm's advantage to be imitated, the more likely it is to have a barrier to entry in its industry and a defensible source of profit.

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage

UMW Hldgs raised to 'outperform'

Published: 2010/01/05

UMW Holdings Bhd, a Malaysian assembler of Toyota cars, was upgraded to “outperform” from “neutral” at CIMB Investment Bank Bhd which sees auto sales gradually recovering in the country.

Its share price forecast was raised to RM8.10 from RM7.25, the research house said in a report today. -- Bloomberg

InsiderAsia model portfolio

InsiderAsia model portfolio
Written by InsiderAsia
Monday, 04 January 2010 00:00

From March 2003 to January 2010 ( a period of 6.75 years), this portfolio has returned a CAGR of 19.2%.

Portfolio review

Our basket of 18 stocks fared extremely well last week, surging 3.2% for the week compared with the FBM KLCI's 0.7% rise. Including our large cash reserves (for which no interest is imputed), the total portfolio value increased by 2.4% to RM524,875.

Our model portfolio's total value and returns represent a significant achievement compared with our initial capital of just RM160,000. We started the model portfolio on March 3, 2003.

Our total profits are very substantial at RM364,875. Of this amount, RM223,866 has already been realised from earlier sales.

Since its inception, our model portfolio has registered a hefty return of 228% compared with our capital of RM160,000. By comparison, the FBM KLCI was up by 96.8% over the same period, even though it has been less representative of the broader market's performance. Plus, our portfolio holds a significant amount of non-interest yielding cash at all times for prudence sake.

We currently have surplus cash of RM127,815 for future investments, and the portfolio's equity weighting currently stands at 76%, which we are comfortable with.

Last week, we had 14 gaining stocks and four losing ones.

HELP International Corp was the week's biggest gainer, rising 11.6% to RM1.92 after reporting a sterling set of final results for FY Oct 2009 that saw net profit rise 31% to a record RM15.5 million despite the recession last year. This continues its double-digit growth trend underscores the education company's resilience and strong branding.

Other major gainers for the week include Muhibbah (up 7%), Faber Group (up 5.2%), Notion VTec (up 5%), Dijaya and Selangor PROPERTIES [] (both up 4.8%). The week's losers were marginal, led by 3A Resources (down 2.6%) and MyEG (down 1.1%)

We are keeping our portfolio unchanged.



Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.


http://www.theedgemalaysia.com/business-news/156667-insiderasia-model-portfolio.html

Cash flow is what matters, not earnings.

Cash flow is the true measure of a company's financial performance, not reported earnings per share.

http://spreadsheets.google.com/pub?key=tN-V5a_7mURGCfW1tcwuQPw&output=html

http://spreadsheets.google.com/pub?key=tufSQpXxzs0bnXVndLmEitA&output=html

At the end of the day, cash flow is what matters, not earnings.

For a host of reasons, accounting-based earnings per share can be made to say just about whatever a company's management wants them to, but cash flow is much harder to fiddle with. 

The statement of cash flows can yield a ton of insight into the true health of a business, and you can spot a lot of blowups before they happen by simply watching the trend of operating cash flow relative to earnings.  One hint:  If operating cash flows stagnate or shrink even as earnings grow, it's likely that something is rotten.



Also read:
Using Yield-based measures to value stocks: Say Yes to Yield
http://myinvestingnotes.blogspot.com/2010/01/using-yield-based-measures-to-value.html

Never forget that buying a stock is a major purchase and should be treated like one

You wouldn't buy and sell your car, your refrigerator, or your DVD player 50 times a year. 

Investing should be a long-term commitment because short-term trading means that you're playing a loser's game.

The costs really begin to add up - both the taxes, the brokerage costs, and the spread - and create an almost insurmontable hurdle to good performance. 

The amount you rack up in commissions and other expenses is money that can't compound for you next year.

Conservative valuation is a crucial part of the investment process.

The key thing to remember for now is simply that if you don't use discipline and conservatism in figuring out the prices you're willing to pay for stocks, you'll regret it eventually.  Valuation is a crucial part of the investment process.

One simple way to get a feel for a stock's valuation is to look at its historical price/earnings ratio (P/E) - a measure of how much you're paying for every dollar of the firm's earnings - over the past 10 years or more.  If a stock is currently selling at a P/E ratio of 30 and its range over the past 10 years has been between 15 and 33, you're obviously buying in at the high end of historical norms.

To justify paying today's price, you have to be plenty confident that the company's outlook is better today than it was over the past 10 years.  Occasionally, this is the case, but most of the time when a company's valuation is significantly higher now than in the past, watch out.  The market is probably overestimating growth prospects, and you'll likely be left with a stock that underperforms the market over the coming years.

Patience

The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

Stick to your philosophy and valuation discipline.  Be patient.

Stick to a valuation discipline: For every Wal-Mart, there's a Woolworth's

"If you don't buy today, you might miss the boat forever on the stock."

Sticking to a valuation discipline is tough for many people because they're worried that if they don't buy today, they might miss the boat forever on the stock.

That's certainly a possibility - but it is also a possibility that the company will hit a financial speed bump and send the shares tumbling.  The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.

As for the few that jsut keep going straight up year after year - well, let's just say that NOT MAKING  money is a lot less painful than LOSING money you already have.  For every Wal-Mart, there's a Woolworth's,

A great company can be a lousy investment. Always incorporate a margin of safety.

The difference between the market's price and our estimate of value is the margin of safety. 

The goal of any investor should be to buy stocks for less than they're really worth. 

Unfortunately, it is easy for estimates of stock's value to be too optimistic - the future has a nasty way of turning out worse than expected.  We can compensate for this all-too-human tendency by buying stocks only when they're trading for substantially less than our estimate of what they're worth (margin of safety).

For example:

There is no question that Coke had a solid competitive position in the late 1990s, and we can make a strong argument that it still does. But those who paid 50x earnings for Coke's shares have had a tough time seeing a decent return on their investment because they ignored a critical part of the stock-picking process:  having a margin of safety.

Not only was Coke's stock expensive, but even if you thought Coke was worth 50x earnings, it didn't make sense to pay full price - after all, the assumptions that led you to think Coke was worth such a high price might have been too optimistic.  Better to have incorporated a margin of safety by paying, for example, only 40x earnings in case things went awry.

Always include a margin of safety into your purchase price

Always include a margin of safety into the price you're willing to pay for a stock. 

If you later realize you overestimated the company's prospects, you'll have a built-in cushion that will mitigate your investment losses. 

The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictabvle earnings. 

For example:

• a 20% margin of safety would be appropriate for a stable firm such as Wal-Mart, but
• you would want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion.

"A great company may not be a great investment."

You can't just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price.  And if the price you pay is too high, your investment returns will likely be disappointing.

"Buffett says the same thing every year."

That's the whole point of having an investment philosophy and sticking to it. 

If you do your homework, stay patient, and insulate yourself from popular opinion, you're likely to do well. 

It's when you get frustrated, move outside your circle of competence, and start deviating from your personal investment philosophy that you're likely to get into trouble.

When you SHOULD NOT sell

By themselves, share-price movements convey no useful information, especially becasue prices can move in all sorts of directions in the short term for completely unfathomable reasons. The long-run performance of stocks is largely based on the EXPECTED FUTURE CASH FLOWS of the companies attached to them - it has very little to do with what the stocmk did over the past week or month.


The Stock Has Dropped

Always keep in mind that it does't matter what a stock has done since you bought it.  There's nothing you can do to change the past, and the market cares not one whit whether you have made or lost money on the stock.  Other market participants - the folks setting the price of the stock - are looking to the future, and that's exactly what you should do when you're deciding to sell a stock.

The Stock Has Skyrocketed

Again, it matters little how those stocks have done in the past - what's important is how you expect the company to do in the future.  There's not a PRIORI reason for stocks that are up substantially to drop, just as there's no reason for stocks that have tanked to "have to come back eventually."  Most of us would be better investors if we could just block out all those graphs of past stock performance because they convey no useful information about the future.

So when should you sell? 
Here are the five questions you should run through whenever you think about selling a stock, and you'll be in good shape.

Did you make a mistake?
Have the fundamental deteriorated?
Has the stock risen too far above its intrinsic value?
Is there something better you can do with the money?
Do you have too much money in one stock?

A reasonable strategy: Selling fairly valued stock to purchase one that is very undervalued

Is there something better you can do with the money? 

As an investor, you should ALWAYS be seeking to allocate your money to the assets that are likely to generate the HIGHEST RETURN RELATIVE TO THEIR RISK.

There is no shame in selling a somewhat undervalued investment - even one on which you've lost money - to free up funds to buy a stock with BETTER PROSPECTS.

Here is what one investor did.

In early 2003, he noticed that Home Depot was looking awfully cheap.  The stock had been sliding for almost three years, and he thought it was worth about 50% more than the market price at the time.  He didn't have much cash in his account, so he had to sell something if he wanted to buy Home Depot.  After reviewing the stocks he owned, he sold some shares of Citigroup, even though they were trading for about 15% less than what he paid for them.  Why?  Because his initial assessment of Citigroup's value had been too optimistic, and he didn't think the shares were much of a bargain any more.  So, he sold a fairly valued stock to purchase one that he thought was very undervalued.

What about his small loss on the Citi stock?  That was water under the bridge and couldn't be changed.  What mattered was that he had the opportunity to move funds from an investment with a very modest expected return to one with a fairly high expected return - and that was a solid reason to sell.