Graham goes to China.

by March 17, 2009

S-shares..
ARHH, EEEeee, omg.. NO!...shit you.. enough with the Shouting/Screaming/Squealing, not much good can be said S-shares nowadays, from inflating accounts to runaway CEOs , S-shares has indeed made an infamous impact to investors all over Singapore, especially value investors out there who taught they bought it cheap, but it went even cheaper on them.

Yet despite all the negative sentiments and great avoidance, could there be value in these S-shares that are soo oversold to the point where market caps are way below Net current asset value? Could the testing of the theory "The best time to find a value buy is when fear is the greatest" be especially applied to S-shares, since people are indeed very fearful of this part of the investment world?
If so what should one do , if one is considering placing some of their investment capital into these shares?

I attempt to answer these questions by using Benjamin Graham's Net Current Asset Value Strategy.

Finding low-risk stocks should be priority number one in this market. Benjamin Graham, considered by many to be the architect of fundamental analysis, described a strategy for identifying deep value stocks, which in his view are low-risk candidates, in his book, “The Intelligent Investor,” published in 1949. Graham’s strategy, dubbed the “net current asset value” approach, apparently works very well.

One research study, covering the years 1970 through 1983 showed that portfolios picked at the beginning of each year, and held for one year, returned 29.4 percent, on average, over the 13-year period, compared to 11.5 percent for the S&P 500 Index. Other studies of Graham’s strategy produced similar results.

Despite the impressive results, Graham’s net current asset value (NCAV) approach is relatively unknown to individual investors. That’s probably because finding stocks meeting Graham’s requirements requires some digging or perhaps for such a long time, no or very little stocks were trading that low.

No Web site provides tools to screen for NCAV stocks. However, it’s not hard, and anyone willing to devote a couple of hours to the task should be able to come up with a few candidates.

Graham's Value Strategy Graham’s NCAV strategy calls for buying stocks trading below their calculated value. Many value stock selection strategies can be described similarly. What’s different is how Graham determines value. Book value, the usual value measure, is a firm’s assets minus its liabilities. Graham does the same calculation, but only includes current assets (cash, inventories, and accounts receivables) in the computation. He ignores long-term assets such as buildings, equipment, patents, and the like. However, he still counts all liabilities including short- and long-term debt, and everything else that appears in the liabilities column of the balance sheet.

Thus, net current asset value is current assets minus total liabilities. Graham’s NCAV strategy calls for buying stocks trading at two-thirds or less of their net current asset value.

That’s a stringent requirement, since most companies have negative NCAVs. But Graham was looking for firms trading so cheap that there was little danger of falling further. His strategy calls for selling when a firm’s share price trades up to its NCAV.

Finding Graham's Value Stocks According to Graham, some of the companies meeting his NCAV criteria could end up failing, so he recommended buying a large number of stocks to diversify the risk. the rest of the Article is from:http://www.sfgate.com/cgi-bin/article.cgi%20file=/c/a/2002/07/01/BU40722.DTL&type=printable

For further reading do visit http://www.grahaminvestor.com/articles/finding-undervalued-stocks-revisited

So, after reading that article i was thinking, if Graham was here right now, and he was taking a good look at these S-shares, which of these shares will he pick according to his NCAV strategy?

Therefore, using the formula given (Total Current assets - Total Liabilities)/ total no. of shares i went to look at 40 over S-shares, barring and deleting the ones i already know that didn't meet Graham's NCAV etc Cosco, i accumulated the results via this excel file.


Excel file sharing link http://www.box.net/shared/fp65zs6krg


Based on the excel file, the second table shows a total of 12 of S-shares that meet Graham's requirement,while the third and final table shows only 7 out of 12 S-shares get selected in the final portfolio of proposed S-shares to diversify upon
How these 7, got selected was based on 3 criteria that would hopefully increase the chances of landing a "higher quality" S-shares that also satisfy Graham's requirement. The 3 criteria are as follows..

1)They have to yield in positive net profit and cashflow for the whole of FY 2008 and this year's 1st quarter results despite current economic downturn! This is to make sure that as of now, their current are not affected by negative net profits burning away the cash reserves. Sino-Environment and sunshine with massive losses to their net profits for FY 2008 failed these criteria and didn't make it into the list.

2)Current asset components has to be more of cash and less other accounts especially receivables. Receivables are accounts that people owe to the company, so by avoiding s-shares whose net assets consist mainly of receivable we avoid a situation when these S-share's receivables are not received thus turning into bad debts and write-offs. Take for example, of the 15 S-shares that pass Graham's test, China Angel Food and Pan Hong Property group didn't make it into the list because their current assets consist mainly receivable and the latter has other accounts like "property under development" in their current accounts.

3)Their business model must make sense and their websites are properly managed/updated. Even simply things like keeping a website updated like broadcasting the latest annual report cannot be achieve, how can the firm take on big stuff like expanding, surviving the current crisis if small simple things cannot be managed well?
With that said, some risks involved in diversifying into the 7 S-shares even though it was filtered by both Graham's formula and me,
-Include currency risks,
-Future use of the current assets by management,
-And of course probability of fraudulent data presented by the firms due to lack of cooperate transparency is still quite high, especially with recent news regarding some S-shares.

However...

One problem i find about using Graham's NCAV strategy is that , if the formula only favour firms that have huge current assets, it leaves out firms that are expanding or hold higher amounts of long term assets..I'm curious about,what is the management going to do with those cash or current assets? Why aren't they expanding or using the assets to improve their economic moat? Isn't that prove that management has no clue as to how to invest their current assets? The NCAV has already factored out ChinaMilk/China Essence/ which i deem a few good firms with a vision and are expanding.

Nevertheless, this current crisis is soo server that it FINALLY presents the opportunity to apply Graham's NCAV on some of these shares, i will keep track of these top 7 S-shares and calculate how much they will yield after a year or so.

Any thoughts on the 7 S-shares? Do let me know :] Happy investing.

Heart of a value investor.

by March 06, 2009

Ouch ouch ouch~It's my 10th mth anniversay of value investing, started since May 2008 when i first started buying equities listed on the exchange. And yes, no doubt like many other value investors out there, i feel your pain. Portfolios have been more or less destoried by the current economic crisis. None of my market gem soo far have exceeded their buying value, some even detoriated to a point that, almost all of its value are gone (drop 80-90%). Soo far, my porfoilio have dropped by a whooping 50-60%, no surpise there of course, since most of my market gems consists of mid-market caps and S-shares. Then MANY people will say, oh you should not have bought into S-shares, S-shares sucks or say something like, you shouldn't have gone into the market too soon, or you should have bought into options to hedge your losses etc.

What i have to say to these people is, you say it best..when you say nothing at all!(In other words shut the hell up!), because your opinions are based on hindsight and by making comments based on events that already happened makes your sound like a hypocrite. I say to you people, if market were to raise drastically or that the recession wasn't as bad as predicted, then the same people with the same comments and opinons will sound like this "Oh you should have bought earlier, why soo fearful? or Damn, S-shares are really super shares, how come you never buy more?"

Nevertheless, what happened, has already happen, now the important thing is what you do now with the time that is given to you? What measures can i take as a value investor?

The first step is to reaffirm my faith in value investing.

I strongly (and will always) believe that value investing is one of the best ways to go about building your wealth. History has already proven it (thru people like Buffet/Filch/Graham), market cycles of upturns and downturns have been going on since the dawn of investing, and no doubt the downside will eventually lead to an upside vice versal.

The second step is to reconfirm the principals i have established with regards to my investing.

I re look at the small piece of parchment i wrote before i bought my very first stock in may 2008. This is what i wrote..

-Buy into good companies at acceptable or low prices
the word "good" is defined by me as companies whose business model is more related to a need and that of a want. The words "Acceptable" or "low" prices is defined as margin of safety relative to it's intrinsic value or Net asset value

-Do not buy into any stocks without doing proper research or understanding regardless of how cheap it is or how many people are talking about it

-Go slow. Do not throw everything into one company and do diversify.

-If mistake are made, write it down, cut loss once fundamentals have changed.

Regards
Yourself at 18th May 2008

The third step is probably to go review my investments with my principals have i followed it soo far?

1st Investment made on 18th May 2008
CHINA MILK
Type:S-shares
Business: Selling Bull semen, milk process etc. Their business is simple to understand, and its more of a need because milk is a commodity and cannot be substitute easily by soybeans. As long as demand is there for products like yogurt/sweetener/ice cream/dairy products/cheese in China, China Milk's revenue is sustainable of course pending the intrusion of competitors, frauds etc

Research: Have been doing for 1-2mths, studied the industry, its historical ROE/Revenue/Net profit/Margins/PTB/Future plans/Capital structure/Risks involved

Price bought at 0.705 per share, give me a discount of 30-40% below its intrinsic value of $1.20 which i calculated with a conservative approach.

Bought only 2 lots, just in case the share price were to drop.

Soo, these are the thought processes that goes thru my head and when I'm planning to buy a certain company. Of course China Milk's share price have dropped to $0.30 as at 6th March 2009. However I'm not upset because, the fundamentals are still there, their business model as expected is still strong (due to increased in revenue/net profit/sustained margins etc) and paper loss was acceptable because i only bought two lots.

Although i have to admit, i made a few mistakes soo far, like buying into SINO-TECHFIBRE at 0.60 2 lots as an Olympic gift to myself without doing much study on it's industry , which is super competitive and their business model is not much of a need. No surprise, Sino-tech went Olympic on me and drop to a disgusting low of $0.10 per share. Then ppl will ask, how come you never cut loss? Well, because i didn't study the industry it was in, and still not interested in doing so, Sino-Tech's internal fundamentals were still very strong for the whole of 2008, until when it came to it's 4Q results, it shocked me that their net profit/margins have dropped by 24% and 50% respectively. Plus, by the time i know about this, the share price have already fallen to $0.12. Soo i was thinking, if i were to cut loss now, i will lose about 80-90% of my investment capital, which i deem pointless to save that $240 (Bought only 2 lots heng arh), its as good as losing 100% of my capital. I rather keep, in hopes that the company will regain its fundamantal :].

Step 4 is to see if my principals need any adjustments.
Probably nothing much to change, maybe i just add this :

The words "Acceptable" or "low" prices is defined as margin of safety relative to it's intrinsic value or Net asset value. But do take note that intrinsic value has it weaknesses like using past data to discount and Net asset value can change drastically etc: REITs due to high valuation from the pass years, that's why margin of safety is very important.

and maybe this

-If mistake are made, write it down, cut loss once fundamentals have changed. Your cut loss, have to be in detailed, either absolute amount (Must cut if it's drops to 0.45 etc) or by percentage (cut when it drops by 50%)

Step 5, what have i learnt soo far

For the entire investing year 2008, i learnt
-To separate noise from real information. Noise might include friends opinions,rumors and some times even analyst's forecasts and buy calls
-Don't be swayed by movement in market prices
-You can copy your investment idol's holdings and try to mimic them, provided that own research and understanding of the company have to be well established first.
-Study the industries in which the company is in. It's economic moat etc.
-Beacuse of the incidents regarding S-shares, even figures and data cannot be trusted. Although this cannot be applied to all S-shares, a note to myself to be alert about this. Check internal control and Auditor's commentary.
-My process of calculating intrinsic value needs improvement, need to study more on Dividend Discount model and Discount Cash Flow model.
-Fundamentals can change drastically, very good exmaple is Sino-Tech Fibre. Thats why , and again i say, margin of safety, buying slowly, deep reserach will more of less lower this probablity of change.
-To countiously learnt from experience investors, their thought processes, their experiences in past recessions, keep a filterated open mind and humble yourself.

Lastly...
As a young value investor, i think the most important thing now is not how much my portfolio have dropped or have been beaten to a pulp by the market. It is, what lessons where learnt, during the this process, such as my investment thoughts,opinions and valuation and how to apply this experience in the future to avoid mistakes or reason for success that have been made since my journey soo far.

China Essence update

by March 04, 2009
China Essence have been agressively (in my opinon) expanding it's operation since mid of FY 2008. It's growth strategies are as follows for the coming year/s

1) Increase Potato Starch production from 170,000 to 250,000 tonnes. (To commence in FY2010 3Q)

2) New production line to increase Potato Protein from 8,000 to 16,000tonnes (To commence in late FY 2009)

3) Likewise Potato Fibre from 80,000 tonnes to 160,000 tonnes. (To commence in May 2009)

All three growth strategies, were funded by internal fundings and bank loans amounting to 570RMB million spent in 2008.

Without the aid of new revenue in place of the new productions by all three sectors, China Essence's Net profit for 9mth to 3Q of 2009, dropped by 8% despite a 21% increase in revenue. This was due to increased in Selling/Distrubution costs up 3.6% to 1.1million, Adminstratives up 35.6% to 8.2million due to expansion and loss of disposal of old factories and lastly finnace cost up by a whopping 103% to 18.4million due to increase in loans paying interest.

With that month full, now i shall touch on the risks that China Essence faces

1)Up coming loans need paying: DBS's $USD 60million (RMB about RMB 460.8million) to be paid by June 2009. Currently China Essence balance sheet states only RMB 262.5million in cash while the rest of the value is stuck in trade receivables 170.1million and inventories 245million. The risk here is, China essence must convert it's inventories and receivables back to holding cash on time and on target or risk borrowing more, especially at times like this when credit is scared.

2)Aggressive expansion plan for upcoming years in late 2009 and FY 2010, apparently these production lines will be activated only if demand meets its supply. According to statistics regarding potato related products as such, demand is at 800,000 tonnes, while supply is about 450-500,000 tonnes. These data is apparently taken from 2007, might not be applicable in 2009-2010, in fact no one knows what will be the actual demand for potatoes in China by 2009/10 all are estimates and cautiously outlooks. If however the demand were to drop drastically, China Essence is more or less doomed, with high interest rates to pay, aggressive expansion of new production lines but cannot activate cause no demand etc, China Essence will have to be forced to sell off it's new assets or old ones to pay back its loans, efforts and hard earned retained earning thru out 2006-2008 will be wasted, share price will plunged further (although its already at 0.19 cents).

Well then again, this are just risks that might not happen after all. Being a shareholder of China Essence, i wish the company all the best in the coming future especially its aggressive expansion, pray that demand will out strip supply still by then.

Note to self* once production begin, expect net profit to increase as well, if not might as well don;t expand if the company cannot earn more then its WACC (Weight Average Cost of Capital).

Good morning,

We understand that investors’ confidence in S-chips have been shaken recently, especially when some of the high profile SGX-listed Chinese companies have defaulted on their payments and suffered from negative media publicity. In addition, the prolonged global economic uncertainties have impacted the earnings outlook of some companies which are susceptible to fluctuations in consumer demand. Due to uncertain economic outlook and poor market sentiment, stock prices of many S-chips have suffered one of their worst declines in recent memory.

As you may be aware, China Essence’s share price has not been spared from the current turmoil. However, the company being one of the leading producers of potato starch products in China, is confident of the long-term outlook of the industry which is well-supported by strong growth fundamentals. While China Essence remains committed to its capacity expansion plans, it is adopting a prudent and cautious approach in order to minimise exposure to unnecessary risks.

If you have any queries or concerns pertaining to China Essence, feel free to call us or drop us a note. You may also wish to browse through the online Q&A which the company conducted with its investors post Q3 FY2009 results. Please click on “Online Q&A” at this link: http://www.chinaessence.com/ir.html Let us know how we can help to address your concerns.

Regards,
Charis
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