In this post, I am outlining my thought process when it comes to investing in listed companies. I am a medium to long-term investor and if I buy shares in a listed company, I will not sell the shares within 1 year no matter what. Due to this self-imposed rule, I have to think carefully before investing in a listed company and be very picky.
I imagine myself buying the listed company and become its sole shareholder. As the sole shareholder, I am entitled to the company’s Net Profit After Tax (NPAT) at financial year-end. However, NPAT is not an accurate figure of how much money I can withdraw from the company via dividend. This is because NPAT includes depreciation and it doesn’t factor in money required to sustain or to expand the company (capital expenditure). Furthermore, NPAT doesn’t include the working capital required to run the company. As such, a more accurate measure is Free Cash Flow (FCF). FCF is the cash generated from business operation minus the capital expenditure and working capital. FCF is the amount of money I can withdraw from the company via dividend. Logically, I should not leave my FCF inside the company’s bank account. I should withdraw the cash and invest in other assets to maximise my return.
There is no correct way of calculating what is the working capital and capital expenditure of the company. For working capital, it is very hard to predict how much money my company needs to operate next year. If I own a private company, I have the flexibility to inject my personal money into my company even if I extracted too much cash from the company via dividend. The same can’t be said for listed companies, if the listed companies want to raise funds, they will need to go through lengthy process to do so and it is expensive. Hence, most listed companies tend to retain some of their earnings as cash on hand instead of giving dividend on the excess cash.
For capital expenditure, if I overestimate the demand for my products and expanded aggressively, I will waste my company’s fund. On the flip side, if I underinvest in my company, my revenue will drop, resulting in a decrease of future FCF. However, there are many listed companies in Malaysia that invest in assets which are not related to their business operation. Furthermore, for growth companies, they will reinvest all the cash flow from operation to expand their business so that they can meet the demand for their products. Hence, it is important to read the financial report and understand where the company is spending its cash. Did the capital expenditure result in a rise in revenue and profit? What are the competitors doing? Often times, I need to exercise my judgement so that I can gauge the true FCF of a company.
How do I value a company? If I can see the future, I will know the FCF of the company throughout its lifetime, I will also know the scraping value of the company (terminal value). I will also know the discount rate. How do we calculate the discount rate? No one knows. If it is that easy, everyone will become rich investing in the stock market. Inflation might be an input in the equation to calculate discount rate. A dollar today is worth far more than a dollar in 10 years. For example, if the business earns RM1000 in the 10th year, the RM1000 might only worth RM700 in today’s money. If I can see the future, I will know the net present value of all FCF and terminal value which is the true value of the business. If I manage to buy the company at 50% of the net present value, I have myself a bargain. This is the principle of value investing, it works for all scenarios, whether I am buying growth companies or mature companies. It’s all about buying a dollar at 50 cents.
I now have a framework to value a business. I need to estimate the FCF, terminal value and discount rate. It involves a lot of guesstimates, it is an art rather than science. I do not know anything about the future and our inflation index is a lagging indicator. There are no certainties in business due to business cycle. Business cannot grow indefinitely and business cannot maintain its profit level forever. Hence, stock investing become a guessing game. This is why Benjamin Graham emphasise on margin of safety, this is to protect investors from unforeseen circumstances which might result in huge losses.
Inverse, always inverse. Wise words by Charlie Munger. Instead of figuring out what are the FCF, terminal value and discount rate, I will first look at the market capitalisation of the listed company. If the market capitalisation of the company is RM1 million, I will imagine that I have RM1 million inside my fixed deposit. If my fixed deposit’s interest rate is 4%, it means I am getting RM40 thousand a year. Using this example, if the listed company’s market capitalisation is RM1 million but its FCF is only RM 20 thousand (FCF yield is 2%), it might be overpriced. On the other hand, if the company’s FCF is RM80 thousand (FCF yield is 8%), it might be a bargain. This is an effective way to gauge market participant’s expectation towards the company. Price to Earning Ratio (PER) is not a correct gauge of a company’s valuation because earning can be manipulated, however, cash flow is harder to manipulate.
Every day, news reported by the press will influence share prices. The movement in share prices is due to price discovery process whereby all market participants evaluate all the available news in the market. At every transaction, there will always be a buyer and a seller. A buyer will deem the share price as attractive to buy whereas a seller will deem the share price as expensive to hold. The share price of a listed company is the aggregate of all opinions from market participants. At every trade there will be a winner and a loser, I am right if the stock prices went up and I am wrong if the stock prices went down.
Is the market efficient? In my opinion, the market is somewhat efficient but vulnerable to the irrationality of its participants: humans tend to overreact and become over optimistic or over pessimistic. My goal in the stock market is to be right most of the time. It is easier said than done. Do I have the mental fortitude to buy the share when its price falls by 50%? If I pull the trigger, what happens if it drops by another 50%? When the share price drops by 50%, the share price needs to increase by 200% to break even.
What do I do if the share I am currently holding drops by 50%? Do I sell or buy more? I have no idea but I know I will need high mental fortitude to weather through a 50% drop. In addition, I don’t know if the drop in share price is due to insider information or the irrationality of the market participants. The odds are truly stacked against me. Luckily, it is easy to spot a good company, but it is hard to tell if the good company is overvalued or undervalued. Then again, even if I buy a good company at a fair or slightly overvalued price, I will be alright.
