Monday, July 31, 2006

Expectations vs Reality

The stock market moves on expectations, not on its actual performance. If the market expects Firm A to grow its earnings by 20% for the next 5 years, the stock will rally 100% in the next 5 weeks. It does not matter if Firm A can actually grow its earnings 100% after 5 years. Similarly, if the street expects Firm B to miss its forecast, Firm B's stock will not wait for the announcement and then plunge. It will plunge today.

Zooming out to the bigger picture, if everyone expects the Singapore IR (i.e. Integrated Resort, where you integrate treadmills with slot machines with massage chairs placed toilets maintained by elite toilet specialists) to be an extraordinary success. It does not necessarily need to be an extraordinary success 5 yrs down the road for money to pour in by the truckload. It only needs everyone to think that it is a success, and everything from real estate prices, to ERP, bus fare, taxi fare, to stock prices except salaries and banana prices will skyrocket.

I used earnings and the IR to explain this phenomenon, but it can apply to everything, from favourable regulation changes to M&A rumours. The stock moves on what the collective thinking of all the investors point towards to and not the actual scenario that will eventually play out. If one can understand this, it is easy to see that this phenomenon has two impact:

1) The market may be wrong, but since the actual scenario does not happen immediately, at the meantime, the market is right. Hence the saying "the market is always right".

2) The market may be right, but it will almost always overreact (e.g. factoring 5 yrs of earnings in 5 weeks) and the scenario is played out in a shorter time frame than expected.

In the long run, the market moves towards the actual scenario and the market corrects its past mistakes. Hence value investing, by trying to estimate the intrinsic value of the company, stands the test of time and the idiosyncracies of the market.

Wednesday, July 26, 2006

Cash and Debt

Perhaps the most important information that can be derived from analysing the balance sheet is whether the company has good financial health. This is determined by how much cash or debt the company holds.
Needless to say, a company that has no debt will be better than one that has. But what is the optimal level of debt? The academic answer will involve corporate finance and things like WACC (pronouced as "whack" as in the sound that is made when you use a baseball bat and smash it on your broker's forehead) which I hope to touch on in future, but not now. For a rough gauge, perhaps we can look at two simple ratios.
  1. Net Debt to Equity ratio
  2. Cash to Market Cap ratio
For a company that has debt, we first subtract cash from its debt to get its net debt level. Next we simply divide its net debt by its shareholders' equity. E.g. Firm A has $100 Debt but $20 Cash and $80 Equity. Hence Net Debt to Equity = (100-20)/80 = 1. This means that Firm A employs as much debt as equity to finance its business. (Which is not very good lah, imagine your wife borrows from you $1000 for every $1000 she has to buy a Prada bag!)
In Singapore, a company with a Net Debt to Equity ratio of 1 or 100% is considered very bad since most listed companies here has no debt. This is especially true for the best companies around.
Now if the company has no debt, then how much cash is enough? The other ratio that people look at is the Cash to Market Cap ratio. This is simply taking cash that the company holds divided by its market capitalization. I would say that a ratio above 20% would be considered very good. This ratio rarely goes above 50% because if it does, essentially you are buying for the company's operations at a 50% discount. (i.e. your wife propose to sell her total net worth to you for $100,000, she has $50,000 in her bank and you get a cut of whatever she makes for the rest of her working life. Sounds good huh?)
To illustrate further, imagine that a company has a Cash to Market Cap ratio of 100%. Essentially, you bought the company for free, because its cash would have paid you the amount you forked out, plus you get the company's business which will continue to generate cashflow FOC.

Friday, July 21, 2006

Components of the balance sheet

The balance sheet can be further broken down to its various components. Reminds me of chemistry when a molecule can be broken down into atoms, and one atom can be broken down into electron, neutron, protron and recently they discovered even these can be broken down into G-strings or something.

So, in the balance sheet, assets can also be broken down into current assets and non-current assets. Liabilities can be broken down into current liabilities and non-current liabilities. These sub-levels will consist of individual components that makes up the basic building blocks (yes, that's it, no more G-strings) of the balance sheet. Below is a not-so-short list of important items to know:


- Current Assets
  • Cash
  • Marketable securities or short-term investments
  • Accounts Receivables
  • Inventory
- Non-current Assets
  • Fixed Assets (Property, Plant and Equipment (PP&E)
  • Intangibles
  • Long-term investments

- Current Liabilities
  • Accounts payables
  • Short-term borrowing (short-term debt)
- Non-current Liabilities
  • Long-term borrowings (long-term debt)
  • Other long-term liabilities (pension liabilities, deferred tax liabilities etc)

Shareholders' Equity

  • Paid-in capital
  • Retained earnings

Friday, July 14, 2006

Why does the balance sheet balance?

Actually, the balance sheet may not necessarily balance. A balance sheet that does not balance is called an unbalanced relationship.

Ok... Sorry for the bo liao joke. But just to share a fact, in most financial models built by analysts, the balance sheet does not balance and they don’t know why.

Anyways, the balance sheet balances because that is how it is defined. By definition,

Assets - Liabilities = Shareholders' Equity

Hence on the balance sheet, Assets are shown on the left, Liabilities and Shareholders' Equity are shown on the right. To illustrate, assuming one bah chor mee start-up borrowed $10,000 to buy a bah chor mee store that cost $20,000 with initial capital of $10,000. Its balance sheet would look like this:

Assets (bah chor mee store) $20,000
Liabilities $10,000
Equity (or initial capital) $10,000

Assets $20,000 - Liabilities $10,000 = Shareholders' Equity $10,000

This has to be the case because initial capital and borrowing add up to the value of the asset that the company has for it to run its business. Now assume that after 1 year, the store generates $18,000 of profits by selling tons of bah chor mee (both with and without liver). Its balance sheet would look like this:

Assets $38,000 (Store $20,000 + Cash from profits $18,000)
Liabilities $10,000
Equity $28,000

Assets $38,000 - Liabilities $10,000 = Shareholders' Equity $28,000

Again the balance sheet balances because any entry into any parts of the balance sheet would have a corresponding cancelling entry on another part. In this case, Assets increases by $18,000 and Equity by $18,000 as well.

Sunday, July 09, 2006

Brokers, analysts, advisors, investment bankers, private bankers etc cannot be trusted

Why do brokers provide research service to their clients? Brokers, or analysts (from sell-side brokers), or investment bankers or private bankers for the matter, thrives on activity. Activity is their friend, and is what drives their profits. For every trade that you make, they will take a cut, regardless of whether you are buying or selling.

Now bearing this in mind, does it make sense for research analysts, working for brokerage firms to make a BUY recommendation and do nothing for the next 5 to 10 years? So, in a sense, research analysts from sell-side can only make short-term calls, to generate churning. They may not realize it, they may genuinely want to analyze companies and give their client good advice, but the system is in place for them to generate churning.

In the markets, to make short-term calls is like throwing a coin and then trying to guess whether it is heads or tails. Research estimates that investment professionals are right 40-50% of the time. The best guys are right 60% of the time. Trusting an analyst to make a correct short-term call is as good as trusting a monkey to throw a dart on chart to determine a stock's target price.

Having said that, brokers are good for information and flows, so use them for that. As far as they want to project an image that they are on our side, we must remember that their interests and ours are not aligned. We must be careful not to let them suck away precious returns in the form of transaction costs.

Wednesday, July 05, 2006


In finance, acronyms are everywhere. Analysts love acronyms as much as women love the hardest rock on Earth and Michael loves to rock every 25 minutes.

Sorry, or was it Michael learns to rock? But since he is learning to rock, perhaps we can assume he loves to rock as well. But that's not the point, the point is we are going to introduce two more acronyms to make you learn to rock as well.

The Cost of Goods Sold (COGS) refers to the direct input costs that is incurred by the company. This would include raw material cost, labour cost, energy cost, depreciation cost etc. For most types of industry, raw material cost or input cost will be the main focus in COGS. For manufacturing co.s raw material cost can be anywhere between 40-80% of COGS.

One important measure of profitability comes in the form of Gross Profit which is Sales - COGS. It measures the direct profitability of the company after all the input costs are deducted. For certain type of industry (e.g. retail), Gross Profit is as important as Operating Profit.

Selling, General and Adminstrative (SG&A) refers to the indirect costs incurred when doing business. As the name suggests, these costs would usually be sales, marketing, adminstrative, logistics (could be classfied under COGS as well though). A cost-conscious company is one that keeps its SG&A low. As a percentage of sales, SG&A varies from 10-40%.

Hence the total cost of the company would be COGS + SG&A, and whatever profits that remain would be the Operating Profit or EBIT (oh another acronym!). If a company has very low COGS + SG&A, it means that its OP margin is very high (40% or higher rocks!) and it is probably piling up cash and you should definitely dig further.

See also P&L statement

Tuesday, July 04, 2006

The profit and loss (P & L) statement or income statement

The Profit and Loss Statement is the second instalment of the three financial statements in annual reports and is the most frequently looked at. It describes how the company has done over the past period in terms of sales and profits on paper. The P & L begins with Sales or Revenue at the top and is followed by all sorts of costs until we arrive at net profit. The following is usually how the P & L is arranged:

1) Sales or Revenue
2) Cost of Goods Sold (COGS)
3) Selling, General and Adminstrative Expenses (SG&A)
4) Operating Income or Operating Profit
5) Interest Expense or Income
6) Recurring Income or Recurring Profit
7) Extraordinary Gain or Loss
8) Profit before Tax
9) Net Profit

The most important no. to look at is 4) Operating Profit (or EBIT: Earnings before interest and tax). This no. is basically the profit that the firm has booked after it has subtracted all relevant costs that are incurred in doing its business. Below operating profit, no.s are subjected to very serious manipulation and hence become seriously unreliable. (That doesn't mean that the operating profit cannot be manipulated though, in fact, everything from Sales to Net Profit can be manipulated, that is why integrity of management is so important.)

In recent years (esp so during the boom), a lot of listed co.s could not even generate a positive OP (i.e. their core business was losing money after factoring in all relevant operational costs). Hence analysts invented another no. called EBITDA which stands for Earnings before whatever it takes to make it a positive number. Well actually it's "Earnings before Interest, Tax, Depreciation and Amortization". It means that if we do not take into account depreciation cost, the co. may be making money.

To put it in another light, say you bought an ice-cream machine that cost $200, you use it to make ice-cream selling for $1 and you declare that you made $200 after selling 200 ice-creams. The cost of the ice-cream machine? Doesn't matter, as long as EBITDA is concerned. Depreciation cost for the ice-cream machine is not a cost under the definition of EBITDA.

See also COGS and SG&A