All-in costs, breakeven costs, cash costs

Analysts of deep cyclicals, industrials, commodities would be very familiar with these terms. These terms are invented by the financial industry to try to help analysts analyze real businesses from their desktops, in plush offices, hundreds or thousands of miles away from where the businesses actually took place. It bears little resemblance of how real ops managers actually thought about their costs or how businesses actually operated. 

All-in costs refer to all the costs that are needed to start and ramp up a business. Take the example of a gold mine, the all-in cost today for digging up an ounce of gold is supposedly $1,000. Today gold trades at $1,100 per ounce. So if gold falls below $1,000, then new gold production should stop since no one would spend $1,100 to dig something and then sell it for $1,000 right?

But wait, all in costs involved sunk cost like exploration, consulting fees, shared costs like HR, R&D and needless to say, actual operation costs like building the mine facilities, transportation etc. Maybe we shouldn't include some of these. What's important is the breakeven costs. This takes out the sunk and shared costs. Breakeven cost is the true operational expenses including depreciation, utilities, transportation etc. So maybe the true bottom for gold prices should be $600-800 per ounce, which is the estimated breakeven cost range.

Ok that made sense, which is why gold has not even come close to those levels in the last few years. But in another familiar highly cyclical industry close to home, we saw how prices crashed below breakeven costs: shipping. Shipping is a notoriously tough sector. Long time value investors would know to avoid these capital destructive firms. Let's take a look at the breakeven cost again.

While most of us would be familiar with container shipping, which is the bread and butter of our beloved national shipping company: Neptune Orient Lines or NOL, looking at the bulk Capesize shippers for shipping bulk commodities would serve to illustrate today's point better. There are 1,000+ Capesize ships globally shipping bulk commodities like iron ore and coal all over the world and the shipping rates of all these ships are calculated into an index called the Baltic Dry Index or BDI. The chart below from the Economist shows how the index traded over the last 10 years.

The infamous BDI index

During the heydays of 2006-08 the BDI traded at 10,000 levels, 2 digits higher than today's paltry 500. Back then it was impossible to fathom that BDI would fall to today's level. It is yet another manifestation how our primitive homo sapien minds worked (we really cannot think long term) and how unpredictable  the future really is. Just as it is today, can we imagine BDI would again go to 10,000 say 8 years from now?  

It is said that the breakeven cost to run a Capesize ship is about $30,000 per day. This breakeven cost would include depreciation of the ship (a huge part of the cost), the fuel, the crew and other miscellaneous including docking fees etc. This $30,000 per day translates to roughly 3,000 on the BDI and it does form a strong support over the last 10 years. Notice the support in 2005-06 and again the resistance/support in 2009-2010.

But in late 2010, the BDI broke the 3,000 low and fell all the way to 1,000. Nobody could figure out how could this happen. No business should operate below its breakeven cost. It means that for every single day the ship was out there, it was losing money. This is negative margin. It should not happen but it did! So analysts came up with another explanation: cash cost.

Cash cost refers to the cost that is needed to operate a business, on cash basis. This is serious. Breakeven cost has non-cash components like depreciation but cash cost means pure cash in and out. No business should operate below cash cost. So, back with the Capesize ships, the cash cost is estimated to be $15,000 per day, this is the money needed to pay the crew, to pay for fuel, all cash involved. So this should be the absolute bottom for spot prices. If prices fell below this, then all the ships should stop running. No company will burn cash to operate any business.

Then in 2015, the BDI broke 1,000. It fell to 500 and remained around there, a 30 year low. 500 on the BDI translated to just $5,000 per day. So theoretically, we can book a Capesize ship for $5,000 a day for some event, like a birthday party or a wedding! It's cheaper to host a wedding banquet on the ship vs in a Singapore hotel. For all that analysis, BDI broke the cash cost level and remained there.

What happened? 

Why did shippers operate below cash cost? Didn't they know that they are burning money every day? Yup they did, but that was not part of the equation the real business operators were working with. All-in costs, breakeven costs and cash costs exist only on spreadsheets. In the real business, Capesize ships have to run every day, it would take a few weeks just to reach anywhere and a few months to fully stop operations. Even worse, these ships were funded with credit. They could not be stopped even if revenue fell below whatever costs.

Stopping ships from running might trigger default and meant paying back the banks whatever loans that was used to finance buying the ships in the first place. So shipping co.s had to operate as long as revenue was not zero. ie as long as the BDI was not zero. Also there was always the hope element. Managers would always be hoping that things would turn. If they bled for just three months, maybe enough ships would be off the market and prices would turn up again. But since everyone thought the same, that didn't happen and BDI remained at 500. That was the reality. 

This is the same story for many, many cyclical industries. We saw that with semiconductors, with commodity prices and even crude oil. There was not such thing as breakeven cost level or cash cost level. The only true real level is zero and market forces determine when the rebound would be. In the end, the message is this: stay away from commodity businesses where companies do not have pricing power but take prices from spot markets. Buy strong businesses with great global franchises. These are the best bets that we could compound our money at above average growth rate over time.

CNY Post - Business Moats. Must Read!

Investing is about finding discounts (or margin of safety). The discount is the difference between the intrinsic value of the company, and the current stock price. Intrinsic values of companies do not change daily. Good companies can grow or compound value. Bad firms destroy value. So the trick is to find good companies, and buy them cheap or at a fair price. They only get really cheap during financial crisis. In normal times, like now, we have to look hard. It is not easy but not impossible.

Good companies have what we call business moats or economic moats. They keep building their businesses around certain factors that keep competition at bay. Business moats are not easy to identify to many laypeople. We would usually think that technology is a moat, or innovation or perhaps government support. But these are usually not moats. They can keep competition at bay for a while. But they are not sustainable. Especially government support or policies which can change in a wink.

True business moats that I see time and again are:

1. Brands

2. Scale

3. Eco-system

4. Switching cost

5. Distribution

Technology is usually not a moat because it is usually copied. Some guy invents a new technology, say, the electric vehicle. For 100 years we pump petrol to make cars move. No longer do we need to visit gas stations to fill up our cars for them to run. Then we see 10 other manufacturers making electric cars. Tesla's moat is definitely not that it makes cars that runs on batteries. It's gonna be something else (if they succeed though, they are still burning cash). But that's topic for another day, let's talk about innovation first.

I think innovation comes together with building brands. By itself, innovation is not enough to defend a business. Innovation is also always copied. But if a strong player has a strong brand, by further strengthening it with innovation, then the business moves towards impenetrability. We discussed Colgate and Swatch before. It’s also the same with Kao (in laundry detergent: Attack & Attack Neo), Diageo (Johnnie Walker) and Reckitt (Durex condoms) etc.

Economies of scale is very important, hence investors always look at market share and the industry structure. If the market leader grows to be a certain size, it is very hard for any competitor to replace it. As the largest player, it will also has the lowest cost of production, the biggest spending power, the attraction for talent to join. It is very powerful. When a certain company has over 40-50% market share in certain products, usually its scale is so huge that it's impossible for any competitors to fight them head on.

Eco-system, switching cost and distribution are similar. By building a network that supplement the business, it makes it hard for customers to leave or for competitors to enter. Facebook built an eco-system locking in the world, our friends, families are all on Facebook, we cannot switch easily. Alibaba also has a strong eco-system with its taobao online shopping mall and now all sorts of stuff including a money markets fund and Alipay and taxi apps etc. Honda’s strong distribution and sales network in motorcycles is why it flourishes in the emerging markets. When your bike breaks down, you need the service guy to be round the corner, imagine buying a Korean bike and nobody can service it! Johnnie Walker/Diageo is also sold in over 100 countries, since 100 years ago. We can find those small bottles of Johnnie Walker in a remote village in Vietnam or Africa for that matter. Diageo’s distribution network cannot be easily replicated. In fact Diageo has brand, scale and distribution, which makes its business moat so huge that it's mind boggling!

I do not think the moat list ends here, there will be other moats. It takes time and experience to understand them. Warren Buffett took 50 years. Bros and gals, we are just starting here... As we learn about these business moats, it helps us become better investors and better thinkers. I learnt by reading daily, newspapers, annual reports, books, magazines. This is a hobby that requires you to read a lot. If you like to invest but not reading, something doesn't gel here. Also, screens are killing our eyes, so nowadays actually I would prefer hard copies. Trees or your eyes. Your choice.

But actually, the most important thing in investing is buying with a margin of safety. The 30-40% discount. Even if you have identified the best businesses with the best moats, it will all come to waste if you bought it at a high price. The high price could have factored in years of growth so your return is bound to be miserable. Say a great business can compound at 10% per year. But you bought it at say, 40% over-valuation, it takes 4 years for catch up. So even if you hold it for 5 years, you would only have earned 10% over 5 years. That's 2% per year. That's miserable return, you might as well put in fixed deposit.

To buy at good discounts is not easy. Hence Buffett mentioned that great companies should be bought at fair value. i.e. if the company compounds value at 10%, then just buy at par, no need discount.  Bcos every year it will deliver you 10%. To get it at a good discount, usually it only happens once in a long while, when markets crash big time. Things would look so bad that buying stocks would be the last thing on your mind. At that point, it takes courage to buy when fear grips the whole world, and the stock markets. Hence, "be greedy when others are fearful."

Well it's Chinese New Year or CNY, it's good to be a bit greedy, just a bit and just for these 15 days.  Happy CNY to all! Huat Ah!

Blue Ocean Strategy

This is the name of a popular book published about 5 years ago that helped improve how the top management of many companies think and how they should come out with strategies to help their company grow.

I started reading this year (yeah, I know...) and found some intriguing ideas that I thought I should share it here. Here are some of those that would really help investors when they do some analysis on companies.

1. Blue Ocean Strategy simply refers to innovations that companies come out with that separate them from the competition. The strategies centre on creating uncontested market space, new demands which was non-existent in the current world (red ocean). This can be done by reconstructing market boundaries by focusing on value-add to end users, combining virtues of different but competing industries or simply creating a new product. The strategy also involve reducing current cost structure while creating new demand thereby helping grow both the topline and the bottom line at the same time.

Some well-known examples of Blue Ocean Strategies would be:

Apple's iPhone (redefining value-add to users)
Apple's iPad (new product, new market)
Nintendo's Wii (expansion of gaming to non-core gamers)
Cirque du Soleil (combining virtue of circus and art)
NetJets (value add of both private jet and commercial airline)
Berries (focusing on fun-to-learn Chinese for English-speaking kids)

2. According to the book, blue ocean strategies are usually not created by new players in the market, nor by technology, nor by big companies. Most companies never continuously come up with blue ocean strategies. The unit of analysis, then, is not a company, nor industry, nor change in technology. The most appropriate unit of analysis is therefore the strategies.

3. Blue Ocean ultimately becomes Red Ocean as competitors catch up. Fat profit margins eventually go down and the whole industry succumb to volume and price competition. ie pursuing profit increase by growing the revenue (usually targeting only single digit improvement) and/or reducing price (by reducing cost and passing on this benefit to clients).

For investors, we should always try to look for companies that are going into wonderful Blue Oceans which they are creating. Companies with strategies venturing in the Blue Ocean ultimately enjoy huge profit growth that are not factored in by the markets. However it may not be easy identifying such companies, hence it is still important to look at the valuation of the stock while betting on Blue Ocean.

This means that as value investors, we cannot buy a Blue Ocean company when the PE is 20x. It goes against the grain of value investing. What if the Blue Ocean turns out to be only a 1 yr phenomenon, then we are pretty screwed bcos when we bought at 20x, and the market is usually discounting a few good years ahead. A good investment strategy would probably be buying into a cheap stock with potential to unlock a Blue Ocean.

However we must also be cognizant that Blue Oceans will ultimately become Red Oceans. Blue Ocean stocks probably see their intrinsic value explodes in the first few years but later plateau out or even decline. This is in contrast with the fantastic Dividend Aristocrats whereby the intrinsic value simply rises over time usually for decades.

One-off businesses

This is the opposite of recurring revenue businesses. Basically, the company sells a product to a customer and that’s the end of it. There is no need for the customer to buy anything else for the next few years and hence no contact between the customer and the product seller for the next few years.

Most products that most companies make fall under this category: cars, massage chairs, LCD TVs, home sports equipment (like treadmills and stationary bicycles), vacuum cleaners, MLM magnetic beds, well you name it.

There is a stark difference between these one-off products and necessity/staples like shampoo, soap, kitchen paper etc. That is: you don’t buy staples products once and do nothing for the next 3 years. You keep buying them. Of course, there are times that the lines can be blurred.

There are a few major shortfalls with this type of business model:

1. The resellers and distributors have no interest to provide good service and they hope to rip off as much margin as they can from the customer since they won’t see them again for some time.

2. Since repeat sales from the same person is low, the company needs to utilize extensive advertising and marketing to sell their products. (well staples may also require this in order to sell, remember the Dove and the Pantene ads?) And the worse part is, if advertising and marketing expenses are cut, revenue falls.

3. The company is forever chasing volume growth because that is what drives the whole business. Hence the company needs to keep opening new stores or to keep coming out with “differentiate” products that are essentially not so different: like massage chair, followed by leg massage machine, head massage device, eye massage eye-wear etc.

4. It also means that sustainable revenue growth is close to impossible. The revenue stream is highly cyclical, following replacement cycles, general economic trends and/or market sentiments.

The prime example in the Singapore context would be OSIM which, by the way, is quite well managed even though it has a crappy business model. But as Warren Buffett puts it, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

For OSIM, the Free Cash Flow track record shows quite clearly that the management is prudent, at least pertaining to generating free cash flow. The company had delivered on average close to SGD 30mn of free cash flow per year over an average equity base of SGD 260mn over the past few years. Which in my opinion is a very significant feat. You just have to give it to Ron Sim.

However the other woes of the company overwhelm this positive FCF. The major blunder was the M&A of Brookstone, which we shall not discuss as it doesn’t really prove the point here.

Stripping out Brookstone, it was still evident that the quarterly sales fluctuated wildly from roughly S$50mn to S$150mn over the past few years. As mentioned, revenue growth needs to be driven by new products, more ad spending and/or new store sales. All of which need money ie less money for shareholders. It is definitely not easy for this business to actually generate good return on capital.

Unfortunately, as the facts add up, this company had an average dividend yield of meagre 1+% over the past 10 years. Its stock price was $0.16 in 2000, went all the way up to $1.36 and fell dramatically back down to $0.04 at its low and is $0.42 today. An investor would have lost money most of the time if he bought OSIM in the past 10 years. Specifically, he would only had made money if he bought in 2000-01 when it was still below $0.20 or in 2008 near the lows.

Good Businesses to Own

There are businesses and there are businesses. Some companies just cannot generate good enough returns for shareholders not because management sucks or there’s too much competition. It’s the business model that’s flawed.

Usually, it’s the high capex ie very high investment needed to buy new equipment to compete. It’s so high that all the money made from good times is not enough to pay for the equipment. And these companies need new equipment to compete in the next cycle.

We all know these industries: airlines, semiconductors, shipping, heavy industries etc.

Then there are these wonderful businesses that keep churning out cash without the need to invest a lot. And the best things is people just cannot stop buying their products bcos it’s a necessity or they are tied down by other factors to buy.

One good example is actually tobacco companies. As Warren Buffett puts it: it costs a penny to make, you sell at a dollar or more, and people just keep coming back for more. And you don’t need new investments. Perhaps just 15 tobacco factories can supply enough sticks for the whole global population of smokers (my guess). Well there’s the moral issue of course…

To summarize, here are some factors that good businesses have

1. Recurring revenue stream – usually coming from

- razor and blade model (printers, games, ipod and itunes)
- necessity item (toiletries, food and drinks)
- contract/license agreement (anti-virus, telcos, utilities)
- consumables (medical supplies, office supplies)

2. Low capex needs

3. Competition is not severe - usually due to

- limited no. of competitors
- dominant market share

4. Strong barrier to entry or moat (branding, technological edge, market share)

5. Pricing Power – related to

- level of competition and market share
- position in Porter forces

6. Growth Potential

We shall talk about some of these factors and companies with superb business models in the next few posts

Game Theory - Part 2

This is a continuation of the last post on game theory

Just for argument sake, let's look at the taxi industry in Singapore. There are 6 taxi companies, ie 6 prisoners. The Big Brother is of course Comfort, with 60% market share, having 14,000 taxis out of the total population of 23,000 taxis. Then there is No.2 SMRT with 3,000 taxis or so.

Currently everyone is just following Big Brother moves and nobody is saboing one another. Which is very good for the industry, as profits can improve for everyone. However, passengers suffer lor. We have to accept price hikes no matter what.

Actually, if you think about it, 1 taxi co. can play punk and not follow suit. E.g. SMART taxi sabo the rest by reducing flagdown rate $2, which is significantly lower than its rivals' $3. By doing this it can actually gain market share. Well that's theory lah, in reality, it will not work bcos

1) Passengers currently cannot choose taxis in a taxi queue, so some kind of mentality change needs to take place, maybe like local celebrities leading the movement of choosing taxis in a queue or something

2) Taxi drivers of SMART may not be smart enough (no pun intended :) to realize this can actually boost their revenue and hence protest fervently to the lower flagdown rate

3) The taxi capacity (or supply) in Singapore is actually very tight, demand for taxis at peak hours dramatically exceeds the taxi population capacity, hence there is no need to resort to cutting prices to gain market share to boost revenue at this stage.

Well all this would change as our society matures. Some day in the distant future, taxi usage may decline and taxi population may actually exceed demand and there will be such a need to resort to price wars.

But even so, as one can imagine, after SMART reduces flagdown to $2, Comfort can simply reduce to $1.90 and crush all competition. So nobody will dare to do such things today. So in this set of prisoners, the outcome is usually quite favourable bcos there is a dominant leader that can dictate others' decisions.

However, back to our distant future scenario, taxi usage is in decline and most taxi co.s are struggling, in desperation, SMART, Prime, SMRT and Silvercab merge to form one company which will now have 50% market share. This new entity then reduces flagdown rate to fight Comfort. We may see the worst case scenario in the prisoner dilemma, ie both parties suffer as they reduce prices but yet cannot gain market share. However this will actually be very good for consumers.

Well, that's a sort of real-life game theory analysis of industries. Hope it can give some insights when you think about the companies that you want to invest in.

Game Theory - Part 1

Game theory is something that was very popular about 10 years ago I think. It tries to mathematically deduce what is the best course of action given a set of circumstances. The most simplistic example would be the famous Prisoner Dilemma.

For the uninitiated, I will give a Singapore version. Say two opposition party members ganna sued by our beloved Gahmen and are put into difficult situations. The Gahmen needs either one of them to confess in order to sue them till their pants drop, so has resorted to interrogate each of them separately whether they want to confess to their crimes.

Gahmen: Hey loser, if you confess your crime and sabo your friend, we will lighten the sentence for you.

Opposition: I will never befray my comrade, screw you!

Gahmen: You sure? Your friend in the next room is going sabo you, you know?

Opposition: You are lying! He will never betray me, we play Goli together one!

Gahmen: Look we are the most transparent, most efficient, most clean Gahmen in the world basically here are your choices:

1) If you don't confess, and he sabos you, you get sued $1mn, he just pays $1000 for wasting our time and walk away
2) You confess and sabo him, you pay $1000 and walk away
3) If you both sabo each other, you get sued $1mn each
4) If you both don't confess, basically we lock you two up for 3 days, you both pay nothing and then you can walk, bcos we have no other way to get evidence

Transparent enough right? So it depends whether you trust your friend or not, if you really think he will not sabo you, then you should not confess.

Opposition: He will never betray me, we play Goli together one!

Ok, so that's Prisoner Dilemma. How does it apply to investing?

Essentially, a firm in a competitive industry is always in the prisoner's situation.
1) If the firm cut prices and competition doesn't, then it gains market share
2) If competition cut prices and the firm doesn't then it loses market share
3) If both cut prices, then both are in a worse situation than before
4) If both maintain prices, or even better, both raise prices then both parties will improve their situations

Well, value investors look for firms that won't get into this kind of situation. Firms in businesses where there is no competition or somehow the firm has a huge economic moat that shields it from price wars or other threats.

In the next post, we shall discuss a real life competitive industry involving Prisoner's Dilemma

Barriers to Entry

To determine whether a company has a business moat ie whether it can defend its turf when competitors come in, we look at what is called Barriers to Entry, one of Porter's 5 Forces. I have identified a few common barriers but I must point out that the list is not exhaustive. Other barriers exist and it takes experience and knowledge to identify them. Again, investing is about life-long learning and hard-work. It is not about get-rich-quick.

Market share
This is the most basic edge a company can have over its competitors. When a company is the No.1 or No.2 in its field, it is simply much more difficult for the laggards or any newcomers to try enter their market. Esp if there are only 2 or 3 big players in the market. This is bcos standards are set and relationships have already been established, and the laggards and newcomers don't have the resources or time to beat the leaders.

Technological edge
This edge can be manifested in several ways. It can be simply authentic technological capabilities, like Toyota with its hybrid technology which it was the first to developed and remain the leader today. Or it can be superior manufacturing technology which allows the company to make stuff cheaper yet have similar or better quality. Like Samsung's LCD TVs.

High initial investment cost
Some businesses require very high start-up cost and this naturally deters competition. Oil/mineral exploration, wafer fabs, a telco network etc. It is simply not business that any Tom, Dick, Harry can start. Sometimes, it can only be started by the government. So when a business can earn a good return and its in one of these high start-up cost sectors, hmm, maybe it can be interesting.

Brand
This is one of the best barriers a company can ever build. Buffett prides his See's Candy, commenting how people will always buy See's Candy even when it keep raising prices. Great brands like Coca Cola, Louis Vuitton, Rolex and our beloved Ipod are simply immune to competition. No matter what the competitors do, people will still buy Coke to drink, LV bags, Rolex watches and the Ipod over Creative Mp3 players.

Regulations
This is the most tricky barrier. Sometimes it works very well for the company in question, but sometimes it simply screw things up. The investor has to become a political analyst to get this one right. Eg. oil fields in Indonesia and Russia. Although major co.s like Shell etc negotiated for rights to sell the oil in these fields some years ago with the respective govts, the contracts were void since oil prices shot through the roof. In the case of Russia, the rights were forced to be sold back to Russian co.s. Suck thumb right? Some value investors stay away from highly regulated sectors altogether.

So, as mentioned, there are other barriers and it takes time and experience to identify them. But when you know the company has got a good business moat, earns a good return, and reward shareholders, then go for it. In Singapore, some co.s that comes to mind would be your mass transport stocks, newspaper, telcos etc.

The Razor-and-Blade Model

In this post, I would like to introduce a familiar business model (for most value investors) that can help most investors in their analysis of companies. It is also a model that entrepreneurs should seriously adopt when they want to start their own businesses. It is a very basic model that can help generate good recurring income and is probably a sign that the company will be in the business for a long, long time and not those fly-by-night bubble tea shops where you see them today but not tomorrow.

This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.

Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.

This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.

For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…

Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!

Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.

The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!

Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.

So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.

What is the "sexy story" about this stock?

In the world of Wall StreetCraft, people like to talk about stories. What is the sexy story for this stock? They would ask, or has this industry got an interesting story?

Translated into English, it basically means this: Tell me why you are buying this stock and make sure it's a fairy tale that everybody likes.

Peter Lynch, the star fund manager for Fidelity some years back, gave this one piece of advice that has got stuck inside my head ever since I read it. If you cannot explain the why you bought this stock into three sentences, then probably you should not buy it in the first place.

For those who have never heard of Peter Lynch, well I suggest you go look him up at Wikipedia. And don't forget to come back here and click on that Amazon link to buy his book!

So the moral of the story is this: Know why you are buying the stock. The reasons should be simple and easy to understand.

In other words, when you buy a stock, make sure that you know its "story". It should be sexy, it should make people say "wow" and make monkeys drool, as if they see truckloads of bananas. But it should also be realistic and the earnings are real.

Over the years, sell-side clerics in the World of Wall StreetCraft have mastered the art of story-telling. They can really spin an infinite amount of fairy-tales and all of them promise a happy ending.

Things like replacing all wires and connectors in the world with Photonics Technology (i.e. light or photon beams), Satellite Mobile Phones (guess most pple remember this one, and the co called Iridium went bust) and my favorite: 3D Holographic Video Phonecalls: some real life technology akin to Princess Leia sending the distress message through R2D2, which was later picked up by Luke Skywalker in the original Star Wars. Too sexy for for your money huh?

But, ultimately, I personally think there are only 3 kinds of stories around. Those that are real and can make you money and then you REALLY live happily ever after one.

1) Growth story: Simple and straight forward, the company has got growth and it is sustainable, valuation is also still reasonable (not PER of 50 or 80x, but say around 15x). Note: the stories listed above (e.g. 3D Holographic Video) sound like growth, but there is a different name for them. They are called concept stocks. There is only a concept, no earnings or sales to justify the story yet.

2) Restructuring story: Company has a good business but somehow cannot generate profits. i.e. very strong sales but no earnings. But one fine day, new management steps in and decide to do something about it. OP margin doubles. i.e. earnings also double and stock price quadruple. Shiok right?

3) Value story: This story can manifest itself in various ways but the basic idea is that you are buying something worth $100 for $40 or less. The difference between this story and the growth story is that the company usually has little visible growth but still the business is very solid and generates good cashflow.

See also Brokers cannot be trusted
and What drives stock prices?

Scenario Analysis or Sensitivity Analysis

This is another no-brainer concept that is given a cool and sophisticated name so that financial advisers and analysts can brag about their knowledge in investment.

For those first-timer to this blog, pls read the relevant posts that are linked here in order to understand what I am trying to say. Most likely this post will overwhelm you if you read it without the background knowledge.

Essentially what you do in scenario or sensitivity analysis is that you try to stress-test your assumptions and see if they work when the state of the world has change.

I guess the easy example here is SIA. In a previous post, I mentioned that SIA earned $1 EPS in 2005 and given that it is trading at $17, this means that its PER is 17x, or an earnings yield of 6% (i.e. you expect SIA to earn you 6% for every dollar you invest.)

Now we need to test how robust is the EPS of $1 (or the earnings yield of 6%), i.e. we want to know if SIA can actually deliver an EPS of $1 when the world has changed. Usually we will set up 3 scenarios.

1) The base case is where the state of the world is as today, goldilocks, not too hot not too cold. In this case, we assume that SIA will continue to deliver the EPS of $1. Hence its PER is 17x and its earnings yield is 6%.

2) Then we have the nightmare scenario where the world goes into recession, i.e. Sept 11 again or some war breaks out. Obviously we have to assume EPS drops to some very low level, maybe $0.10.

3) And finally we have the blue sky scenario where the world prosper and SIA lives happily ever after and EPS becomes an astronomical no, like $10.

After that, if you like doing math, you can acsribe probabilities to each of the state and calculated the expected EPS of SIA. For me, I am just interested in the nightmare scenario. I want to know if it happens, is SIA still cheap. Obviously, if the nightmare scenario comes true, SIA can only earn me 10c for every $17 of the stock, I might as well buy Singapore T-bills. Hence I will not buy SIA.

The fun part here is how to ascribe an EPS to the nightmare and blue sky scenario. What is the appropriate no.? Is 10c low enough for the nightmare scenario? In which case PER goes to 170x and earnings yield become 0.6%? Or is it 1c, then PER goes to 1700x. Woah, that’s better than Google at its peak (PER 400x or so I think).

I would say the success rate of this kind of analysis only gets better with experience. It also depends on your view of the world and your emotional state and personality. A conservative investor will think that EPS goes to zero and hence will not buy SIA, bcos he thinks SIA will simply drop like a rock if another catastrophe strikes. A greedy and bullish investor who have only seen bright and sunny days will think that SIA will fly no matter what happens. And he will say SIA is still very cheap at PER of 17x.

See also SWOT analysis
and Investment philosophy and process

Industry Life Cycle

According to Buddhism, there are four phases in Life: Birth, Aging, Sickness and Death. The funny thing is, business schools teach a similar theory about industries.

This is the what makes investment interesting I guess. It is not just about making money. It encompasses knowledge from different fields like philosophy, religion, social science, accounting, economics, finance etc. Which means you have to know a lot before you can invest and make money. Investment is about knowledge. Investment is also about your style, your view of the world and about your ability to stomach losses and conquer your greed.

Okay, back to the main topic, so similar to Buddhism, industries follow a four phase life cycle:

1) Infancy: Few players, growth rate: 10-20% e.g. Fuel Cell
2) Growth: Many players, growth rate: 50-400% e.g. LCD TV
3) Mature: Ogliopoly, growth rate: 5% e.g. Oil majors like Shell
4) Decline: Ogliopoly, growth rate: -5 to 0% e.g. Photo film

Industries can be broken down into these four phases and depending on which phase an industry or company is in, we can see some characteristics pertaining to that phase and frame our expectations accordingly.

1) Infancy: This phase marks the beginning of a new industry, technologies are only recently discovered and business models are still evolving. Growth is limited due to limited demand and lack of funding and interest. Usually marks the 1st 5-10 yrs of a new industry.

2) Growth: At a certain point, an infant industry hits an inflexion point and starts to grow spectacularly. Competitors also start to enter the industry causing prices to come down. But declining prices lead to even stronger demand for products. Stock market starts to get very interested at this stage. Growth phase usually marks the next 10-30 yrs of strong growth.

3) Mature: A growth industry will eventually mature when penetration rate reaches a certain level and/or demand runs out. Growth rate declines to single digits. Weak players exit the business as they cannot compete at low prices and low sales volume. Industry usually consolidates to a few strong players.

4) Declining: This is similar to death in Buddhism life cycle. The industry cannot continue to exist as there is no longer any demand for its products.

It is important to note that these are theories. They do not work perfectly in the real world. Some industries go from Infancy and straight to Decline (e.g. MD players?). Some enjoy growth for 40-50 yrs (autos: is it still growth or mature?). Some industries reach mature stage in 3 yrs (Internet auctions, online stores?). Some industry simply cannot fit into any phase (e.g. consulting?).

Once we understand which phase an industry or company is in, we can better size up its growth potential, investment return and other big picture aspects.

See also Porter's 5 Forces
and Secular Trends

Industry Food Chain

This reminds me of primary school days, when the small fish eats plankton and the big fish eats the small fish and all the crap right? Well with production and business, it's almost the same.

Industry food chain refers to the process by which raw material is being passed through different manufacturers as semi-finished products and finally being made into end-products for the consumer. The most famous one is the semiconductor food chain. But since this food chain is far too complicated, even for sell-side semiconductor analysts, I shall use another relative simple one.

Honey -> Bee -> Bird -> Human

Ok, ok, before you click the "x" at the top-right corner,

Wafer suppliers -> Foundry -> Chip makers -> Consumer electronics

Well that's the simple semiconductor food chain, but what makes the actual chain so complicated is that at every level, there are equipment suppliers and fabless design houses and testing equipment makers and OEM manufacturers so the whole thing turns into a huge spider-web which is good for putting around your workstation to impress sweet young secretaries.

Ok, but what's so useful about learning this? The short answer is Bottleneck. By understanding the food chain we can find out where is bottleneck. i.e. the point in the food chain when there is less capacity than demand, or where there is limited no. of players and hence they have the bargaining power over everyone else. (See Porter 5 Forces.)

Take the example of the hard-disk drive (HDD) industry. HDD is part of the huge spider web within the IT/semiconductor food chain. If we take a closer look at its food chain specifically, it is something like

Materials (Magnets, metal screws, glass discs)
-> Components (recording heads, motors, connectors)
-> Hard-disk drive makers (Seagate, Western Digital etc)
-> Consumer electronics (PC, Ipod, HDD-DVD recorder etc)

There are currently only 5 or 6 players globally in the assembler space. Seagate being the market leader with 40% share, followed by Western Digital and some Japanese and Korean players. However there are countless material suppliers, component makers, as well as consumer electronics players.

2 years ago when Ipod became the No.1 item on everyone's wishlist and when Flash memory was still too expensive, HDD was in super short supply. A bottleneck formed at the assembler space gave HDD assemblers huge bargaining power over its suppliers and customers.

As we can expect, HDD assemblers' stock prices shot through the roof together with Apple and those who have bought these assemblers laughed their way to the bank. Well that is if they sold, today flash memory is rapidly replacing HDD and we all know what is happening now.

See also SWOT analysis
and Secular trends

Porter 5 forces

Michael Porter, elder brother of Harry Potter, wrote and published a book in 1980 called Competitive Strategy that helped frameworked how we should look at an industry and the forces that interact with the various companies in the same industry. Ok, just kidding hor, Michael Porter is a real academic while Harry Potter is a wizard in a bestselling septology i.e. a story with seven episodes!

Well what Mr Porter said was somewhat common sense but they will nevertheless teach it in business school and set 1 exam question on this per semester. Anyways, the canonical Porter's five forces are

1) Existing competitive rivalry between industry players
2) Threat of new market entrants
3) Bargaining power of buyers
4) Power of suppliers
5) Threat of substitute products (including technology change)

An industry leader/formidable player should be able to tackle all the forces with ease. As an example, let's look at the aircraft makers: Airbus and Boeing.

1) Rivalry between these two players: yes they are somewhat bitter rivals, but on the whole, because there are only two players, price competition is quite limited, and profitability remains high.

2) New market entrants? Not likely, since they are the leaders with all the experience, no airline will think of getting planes from new entrants. Well maybe African airlines buying cheap Russian planes, but overall, not a big threat.

3) With over 100 airlines, basically the airlines don't have any bargaining power. Boeing and Airbus set the price, airlines just accept. If they don't there will be 99 airlines waiting to buy anyway.

4) Suppliers, well depending on the parts, suppliers can be quite powderful. Especially high-end stuff like engines etc. Hence they (Boeing and Airbus) may lose out here.

5) Substitute? Er like flying cars? Or high-speed broomsticks? Well sorry this is not Hogwarts, so in short, no threat from substitutes.

So Boeing and Airbus are in a good position, of the 5 forces, they have the upper-hand in 4 of them. Of course, this is just one aspect to look at one industry. Will be introducing more!

See also SWOT analysis
and Secular trends

Secular trends

Secular trend is one phrase that makes monkeys on Wall Street salivate profusely. It is as if they see bananas coming to them in tsunami waves or something. Well actually, investors probably also imagine tsunamis of dividends pouring over them and that's why they scramble to ride these trends at all cost.

Our world is defined by huge trends or secular trends that last for some time, usually 5-10 years. In the 60s and 70s we have autocars, 80s we have Japan Inc, and the beginning of the 20yr US bull market. 90s was IT and Tech, Media, Telecoms (Ouch!), and now China and commodities.

Note: more often than not, the trend goes into bubble mode and the Greater Fool Game begins. It it important to know the difference and decide for yourself if participating in the Greater Fool Game is what you want.

Betting on these trends will reap you rewards far bigger than day-trading or any other money-making scheme you can ever think of, including building 2 x Integrated Resort to attract oil money, Chinaman yuan, high rollers' money and dunno what else.

Ok, perhaps the reward is not as big as being faithful and good to your spouse. Real life example: University Don flirting with China Gal. Umm, there are other ways to bet on China okay, and they don't need $7k per mth.

Anyways, identifying such trends require good grasp of global condition and some innovative thinking. This I would say 99.99% of the brokers and their analysts lack. For a good reason. If you identify a trend, you need not buy and sell all the time. Just ride with trend until the cows come home. And this is not good for the brokerage business.

So what are the trends going forward? By right, you should go think for yourself, but since I am writing this, and you are reading fervently, I guess I am obliged to share. Most of these are not new, so pls don't say I have no orginality or what.

1) Silver market: The world is aging rapidly as the baby boomers retire, cash in their pension money or CPF, they will need to find ways to spend it. In most other countries, they spend in on travel, buying houses, cars, buying LCD TVs etc. Hence the global boom in real estate, LCD TVs and autos. But sadly in Singapore, our baby boomers spend it on? *Drumrolls* China Gal! So Buy Prada.

The stock, not the bag.

2) China consumer market: Let's face it, The 21st century belongs to China. We have probably only been through 1/3 of the big China story. So far they simply built 10,000 factories and produced enough stuff to drown Mordor's army 2 times. The Chinese consumers haven't even started spending yet. When they do, it will be interesting.

Again buy Prada. Okay enough of Prada, buy Ferragamo.

If you think about it, in the past 5 yrs, every big secular trend was actually due to China. Why did commodities go up? Why did steel prices tripled? Why did oil price shoot through the roof? Why can Walmart conquer the world with its cheap stuff? China. China. China.

Why is Singapore building 2 x Integrated Resort? To create more jobs for China gals and get more University Dons to spend $7k on China Gals. In short, China again.

Although the whole world has been talking about China for the past 10 yrs, we are probably not finished yet. China is probably Singapore in the early 80s. We have more to go.

Of course, there will be other secular trends. They will be up to us to find out. It will probably be difficult. You need probably 10 mental workout per week, and talk to 20 think-tank people regularly. But when you do, pls update this blog.

See also Good stock but not a good buy
and Mr Market

SWOT Analysis

SWOT Analysis is a method developed to analyse an individual company through a framework. It is much loved by Wall Street and you can usually find it in the Initiation Reports of companies by Wall Street analysts. This pretty much tells you that SWOT analysis is perhaps as useful as a piano is to a monkey who is hungry for bananas. i.e. quite useless. Nevertheless, let's take a look.

SWOT stands for Strengths, Weaknesses, Opportunities and Threats which is basically four aspects of looking at a certain company and see if it is worth investing. The words are probably self-explanatory but as an example, let's see how it works.

Strengths: Usually depicts the company's plus points, like having a high market share, or a competitive edge over its rivals, or the ability to raise prices despite public outcry, with the support from the Government (yup that's the right spelling, also don't forget the capital G).

Weaknesses: The company's minuses, like high operating costs, weak product pipeline, poor branding, poor customer service, zero disclosure to shareholders and/or potential investors, labelled as an ugly duckling on Wall Street (that's pretty bad, because Wall Street doesn't like swans either) etc.

Opportunities: Events that will affect the company positively, like a new market for its products, or potential for the firm to be acquired, or the ability to acquire other smaller competitors, or Gahmen, oops sorry, Government support etc.

Threats: Things that will threaten the company's position. E.g. unfavourable regulatory changes, entry of a formidable new competitor, technological evolution that will render the co's product useless, consolidation between suppliers or clients etc.

So that's how SWOT does it. Systematically analyze four aspects and determine the company's position in each of them. Perhaps the takeaway behind SWOT is not just looking at the four aspects but more to analyse a company using a framework or system. This will help one to see the company is a better light, and hopefully make a better investment decision.

PS: Takeaway literally means "da bao" i.e. taking some good food/good babe back home or taking away an important lesson to be remembered.

See also Expectations vs Reality
and Financial Ratios