Monday, August 21, 2006

More Net Profit

Net Profit may be subjected to multiple rounds of creative accounting (i.e. legally faking no.s or cooking the books to produce no.s) but it does measure the profit that should go to shareholders. To put it into another perspective, if the company has integrity and assuming that it does not cook its books, then Net Profit is a true measure of the profit attributable to shareholders.

As a rule of thumb, Net Profit should be 50-70% of Operating Profit. This is worked below:

Assuming that a company has $100 in operating profit, then

Operating Profit $100
Recurring Profit $90 (say interest expense is 10% of OP)
No XO loss or gain as it should be
Tax rate 20% (i.e. tax is $18)
Net Profit $72

Hence a good co. would have a Net Profit of roughly 50-70% of OP, depending largely on the tax rate. In Singapore, however, there are a few companies that has Net Profit that is greater than Operating Profit. This is usually because they have a lot of profit gained after OP like sale of investment in stocks, properties or simply income from cash holdings.

The most prominent example is SPH. For several years, SPH sold various investments that it held in Singapore stocks like Starhub, M1 etc. These huge gains from investments are allocated at the Recurring Profit level and hence even after taxes are deducted, Net Profit is much higher than it should be, sometimes even higher than OP.

See also P&L Reloaded: Net Profit
and P&L Statement

Saturday, August 19, 2006

P&L Reloaded: Net Profit

As with Hollywood as its sequel, prequel and trilogy and quadrilogy. We revisit the P&L or income statement with a vengeance. This time we vent our anger on Net Profit.

The Net Profit is usually the last line in the P&L statement and is usually the number that is most looked at, much like the youngest and most beautiful daughter in the family. In reality, this no. bears little significance to the operations of the company but as we know Wall Street, they like things most when they do not make sense.

Net Profit has little to do with the company’s business because it measures a lot of "costs" that are progressively less relevant to the company's core operations. To recap, we all know that the most relevant costs of any business operations will be

  1. Cost of Goods Sold (COGS)
  2. Sales, General and Adminstrative Expenses (SG&A)

The no. after these costs are subtracted is the Operating Profit (OP). After OP, interest expenses are deducted, because lenders take the first cut of what is left as they always do. Of course the some companies do not borrow, so they have interest income instead. The number after interest is accounted for is called by various names like Recurring Profit or Ordinary Profit or Earnings Before Tax and extraordinary items etc.

After this, we have extraordinary losses or gains (also known as XO loss or gain, not to be confused with the other XO which is a hard liquor). This is where companies hide all the bad stuff usually and you see extraordinary losses or gains every year, which makes you wonder if they are extraordinary or exactly ordinary.

After that, we have taxes and after taxes we finally come to Net Profit, which is profit that is attributable to the shareholders of the company. (If you think about it, shareholders are ranked behind 1. Customers 2. Workers, 3. Debt holders, 4. Disasters 5. the Taxman, which makes investors the lowest lifeform.) You must understand that at every level, no.s are subjected to manipulation and hence when it comes to Net Profit, this no. actually has no integrity left.

Nevertheless, when Net Profit is divided by the no. of shares outstanding (i.e. no. of shares issued by the company which is still in circulation), we get another big ticket no. called EPS, or earnings per share. EPS is the most talked about no. on Wall Street because it is used to calculate the Price Earnings Ratio, or P/E ratio. And this ratio determines how cheap or expensive is the stock.

The Guru = Warren Buffett (a.k.a. Sage of Omaha)

With numerous references to The Guru on this blog, I reckon I should give a proper introduction to the person who made this blog's existence a reality. This is really for those who are asking yourselves, "What the heck is Warren Buffett?".

Warren Buffett is not a kind of eat-all-you-can buffet typically charged at $25+++ in Singapore restaurants. Warren Buffett is the world's 2nd richest man and the world's first person to donate 85% of his enormous wealth (which is roughly USD 40bn or 40% of Singapore's GDP) to charity. Imagine the whole of Singapore donating 40% of their salary to NKF.

He is also a practitioner in a style of investing known as Value Investing which has made a handful of people very rich. This is the reason why it is promoted on this blog.

For a detailed biography of Warren Buffett, try googling him or alternatively you can go to this link at Wikipedia on Buffett. No, I am sorry, Warren Buffett does not have a blog. He only tried going online a few days ago to play bridge with other people not living in Omaha, which is somewhere in the middle of nowhere in US.

See also Mr Market
and Margin of Safety

Friday, August 18, 2006

The Greater Fool Theory

The Greater Fool Theory or Greater Fool Game looks at stock bubbles, Ponzi scheme and MLM from another perspective. Essentially you try to get into the game as early as possible and sell your stuff to the next person or the Greater Fool. Now the next person is the Greater Fool because by buying what you have proposed to sell, he probably doesn't gain anything (or every little). Try visualizing magnetic beds or slimming pills or purple crystals that claim to do wonders but the effects are impossible to quantify.

So the only way he can get out of this trap is to find a Greater Fool (than himself) and sell it to him. As long as you are not the Greatest Fool, you will win the game. In MLM and Ponzi scheme, the Greatest Fools are people at the lowest level of the pyramid. The reason why MLM and other Ponzi Scheme and stock bubbles can carry on for some time is because the Greatest Fool or Fools have not joined yet. So those in the game can continue to have fun.

A true value investor however, does not like to participate in the Greater Fool Game. He believes in buying things below their intrinsic value and in the Greater Fool Theory, intrinsic value of any product or stock is way, way, way below its market value. (i.e. you are buying something worth $1 with $100.)

There is no right or wrong about making money. Depending on your investment philosophy, you can engage in Greater Fool Games all your life and make truckloads of monies. And throw a few shillings to the down-and-out value investor staying true to his philosophy. (FYI: Warren Buffett lost 50% of his wealth during the IT bubble by staying true to his invesment philosophy.)

Just make sure that you are not the Greatest Fool.

The Pyramid or Ponzi Scheme and the Positive Feedback Loop

As some of you would have guessed after reading the previous post, a bubble is very much similar to a Pyramid Scheme or Ponzi Scheme. These are essentially elaborated setup that promise riches to those who join but are bound to fail because they are not based on fundamentally sound economics.

*Pls google those bombastic terms if you are still blur, confused, wondering what the heck pyramids in Egypt have to with do soap bubbles or thinking that Ponzi was a disciple of Sun Zi, the great military strategist in China 2,000 years ago. If you did, don't worry, I thought Ponzi was a disciple of Confucius or Kong Zi*

A Pyramid Scheme or Ponzi Scheme (also exhibited in other forms like Rat Society, MLM, etc) has two characteristics:

1) The person who joins have to cough up some amt of money
2) The person can recruit others to join under him, the recruits in turn cough up an amt and the person on top gets a cut

This scheme essentially benefits early birds as they are the ones who can enjoy more income as more and more people join. But it is bound to fail because it is not based on fundamental economic growth and no. of people who will join will eventually run out.

However at the start, the early birds usually enjoy some success. This is because as more people join them, they see money rolling in and they reaped back their initial investment. This is called the Positive Feedback Loop.

The success of the early birds convinced them and their friends that the scheme worked and they fervently recruit more people. This is what happens in stock bubbles. Early adopters buy stocks and see their wealth grow. They spread the word, more people join them. But since this is not based on real economic growth, at some point, there will be less buyers than sellers and everything collapses.

MLM is an ingenious way that masks a product into the Ponzi Scheme. The selling price is set ridiculously high to feed those at the top of the pyramid. But it is also bound to fail because there will be a point where you simply cannot get any more buyers to cough out those exorbitant rates for mildly useful health products, magnetic beds or the other shady products with unmeasurable usefulness.

The same goes for internet ads promising huge returns in days or weeks. It will only work if you are an early bird. Chances that you are an early bird is as good as finding a $10 bill in the middle of Orchard Road. (i.e. very low lah, bcos someone would have picked it up. But not impossible.)

Thursday, August 17, 2006

Irrational Exuberance

Once in a while, the stock market goes into bubble mode, or what the guru terms as irrational exuberance. In Singapore, this phenomenon probably exhibits in one of the following ways:

1) The STI chart looks like the left half the Eiffel Tower in Paris
2) Two or more friends are switching career into finance
3) Local TV did a drama/talk show/charity program on stock trading
4) A taxi driver recommends a stock to you
5) You actually think if you should buy the stock he recommended
6) This blog gets prime time coverage on Channel U
7) Your grandma wants to open a brokerage account
8) The market cap of a sexy stock is bigger than the GDP of some countries in S.E. Asia

You get the idea. For those of us born before 2000, we've been there, done that and some are still licking our wounds but secretly wishing that those days will come around again, and this time we will do it right. Right?

Well let's see what really happened. In the World of Wall StreetCraft, probably around 1995, some cleric created a portal and invited some friends to join him. But the catch was that the friends had to pay a small sum of money to buy their entrance ticket. They did.

For a while, the group of friends were feeling good. The portal offered warmth, companionship and a lot of promise. It linked to different places in the world and new technologies were created. Soon more people joined, and for everyone that joined, people in the portal enjoyed some income.

As more and more people joined, the portal started to get crowded, boundaries were pushed out to acommodate more people and entrance ticket got expensive. Some left the portal but more people joined. Entrance ticket got ridiculously expensive but a lot of other folks did not want to be left out and paid up.

By now the portal looked very roundish, yes like a bubble, and full of people inside quashed around but getting very euphoric. This was because the value of their entrance tickets is worth more than what they could have earned in 20 lifetimes. They felt like gods and goddesses in heaven eating grapes and stuff. This was when grandmas in Singapore heard about the portal and wanted to join as well.

Now the grandmas in Singapore were the last people to join the portal and suddenly everyone realized that no more income can be gained since everyone was already in. This was when they realized the portal was getting stuffy as well and everyone wanted out.

Overnight as everyone rushed out, entrance tickets became worthless and a lot of grandmas and clerics who bought the tickets late lost their shirts. In fact they lost everything they had, some moved on, but some remained in fantasy, constantly hallucinating about the good days where they were eating grapes and stuff in heaven.

Actually not everyone joined the portal. A group of obsured people known as value investors watched the whole portal episode by the sidelines. Cajoled to join but they knew better. They knew what was irrational exuberance. In the end, they were the ones who picked up the pieces, drank the wine and had the last laugh.

Wednesday, August 16, 2006

Financial ratios

In Singapore, when you divide one no. by another, it is usually to achieve some specific purpose and you will forget all about it in like 2 seconds. E.g. you go to a restaurant with 12 friends and when you get the bill, you simply divide it by 12, and forget all about it.

On Wall Street, when you divide one no. by another, it has divine meaning. Cult leaders and religious factions are formed. So much so that some no.s have an ® mark beside them. And R stands for Religion.

Ok R does not stand for Religion, but it is true that some no.s when divided by another has an ® mark beside them. These no.s are also known as financial ratios.

Wall Street thinks that by divided one no. by another, you can normalize things and hence comparison can be made for different co.s. Much as I despise Wall Street, I think that sometimes ratios make sense. E.g. when I divided the dollar value of all the presents I bought for my wife by the no. of times I skip washing dishes, I can determine the efficiency of the presents. It works out to be $12.6 for per dishwashing session. Anyone needs some financial planning on dishwashing?

Anyway, below is a non-exhaustive list of financial ratios and their meanings.

1) Operating Margin (OP/Sales): Efficiency of the firm's operations, this no. range from -90% to +90%, the higher the better.

2) Asset Turnover (Sales/Total Asset): Efficiency of the firm's assets in creating sales, this no. is usually 1.x, the higher the better.

3) Return on Equity (Net Profit/Equity): Rate of return attributed to shareholders, this no. is usually 5-40%, on average around 20%, the higher the better.

4) Return on Asset (Net Profit/Total Asset): Rate of return attributed to the whole firm, this no. is usually 2-30%, the higher the better.

5) Dividend Yield (Dividend per share/Share Price): Rate of return of dividends, this no. is usually 0% to 10%. In Singapore, anything higher than 5% is considered very good.

6) Other ratios that we talked about: PER, PBR, Net debt-to-equity, cash-to-market cap, EV/EBITDA.

7) Another 10,016 ratios that we did not talk about, created by Wall Street analysts. Maybe you can still find 1 or 2 useful ratios in there.

Essentially ratios are quite useful when you want to analyze a company but try not to be a cult leader and read into ratios religiously. By that I mean you try to contemplate if $12.5 per dishwashing session is more efficient that $12.6 per dishwashing session. They are useful but not that useful. They give a sense of how the company is performing, you still need to do more homework after that.

Tuesday, August 15, 2006

Financing cash flow or CFF

Financing cash flow (or CFF) is usually the last instalment in this trilogy within the trilogy (phew!) i.e. that last portion of the cash flow statement and it deals with the financing needs (both equity and debt) of the company. This would usually involve repayment of debt, or increase in borrowing, dividend payment, equity capital reduction, increase in equity, share buyback etc.

Ok, ok, this may be too heavy, let's go back to Finance 101. A firm needs capital to run its business. There are two ways to get capital,

1) you borrow from bank, this is call debt
2) you raise money from the stock market, this is call equity

Financing cashflow deals with what the firm does with its capital. Increase debt? Decrease debt? Increase equity? Reduce equity? Pay dividend? Or outright equity reduction etc.

Hence, it would be useful to observe how the company is changing its capital structure from this part of the statement. Just like it would be useful to see if your spouse finance her spending needs through debt or something else (most likely through you though), and since buying a company entails as much commitment as sleeping with someone for the rest of your life, it pays to know.

In Singapore, a lot of companies are trying to reduce its equity base (SPH, Singpost etc) in order to make some financial ratios (like ROE) look good. (i.e. some spouse is trying to fake financial stability here) However that is just part of the story, the other part is *drumrolls* to return money back to their No.1 shareholder: Temasek Holdings. Of course, minority shareholders will stand to benefit as well, hence while it last, it would not be a bad idea to invest in these stocks.

Sunday, August 13, 2006

Investing cash flow or CFI

Investing cash flow (or CFI) is usually the 2nd portion of the cash flow statement and it measures the money that the firm use for its investment activities. The most important no. here is the Capex no. Now "Capex" may sound like a new brand of designer clothes but it's not. But maybe someone can start one hehe. Anyway, Capex is the short form for Capital Expenditure. This is what the firm needs to invest in (usually in new equipment, new technology or new offices etc) in order to stay competitive in its business.

This no. however is not labelled as "Capex" in the cash flow statement but usually goes by some obsure label like "Acquisition of New Property, Plant and Equipment". Why is this so? One good reason that I can think of is because auditors love to make life difficult for a lot of people and sell-side analysts, investor relations managers get to keep their jobs by having to explain what "Acquisition of New Property, Plant and Equipment" really mean.

Other no.s that are quite boring that goes into investing cash flow as well will include:
1) Sale of Property, Plant and Equipment (opposite of capex)
2) Purchase and Sale of Investment Securities
3) Acquisition of new subsidiaries or associated companies etc

One need not worry too much about those no.s unless they have a few more digits than the rest of the no.s in the cashflow statement. Meaning they are super big or super negative and it pays to know why that is so.

Sunday, August 06, 2006

The Cash Flow Statement

The last installment of the financial statements trilogy (which is usually the most boring as well) is the cash flow statement. To most people, the cash flow statement is of least importance and perhaps that is why it is always found after the other two. However, as with trilogies, it is also where you can find the truth about companies. But son, you can't handle the truth!

The conventional thinking is that it is easy to manipulate earnings, costs or even sales but it is much harder for companies to manipulate cash flows.

Cash flow measures the actual inflow and outflow of cash into and out of the firm. Hence while sales can be manipulated (e.g. by recognising sales from the future), a cash outflow is a cash outflow. When a cash outflow becomes a cash inflow, there are only two explanations:

1) This is fraud, the no.s are fake, don't trust them
2) The money is in the washing machine, going through the laundry

A company that has a poor cashflow is something to look out for. It is usually an early warning for bigger trouble to come. Avoid at all cost.

The cash flow statement is also further classfied into three sub segments (whoa...a trilogy within a trilogy...)

1) The cash flow from operations or operating cash flow (CFO)
2) The cash flow from investments or investing cash flow (CFI)
3) The cash flow from financing or financing cash flow (CFF)

The most important no. to look out for is undoubtedly the operating cash flow (CFO), *For the really blur people reading this, pls don't get confuse with the other CFO which stands for Chief Financial Officer*.

This no. (i.e. CFO) measures the actual cash inflow from the firm's core operations and it should always be a positive number. If it is not, it means the company cannot earn money from its core businesses and all alarms should sound and you should press the panic button and unload everything, if you own it, and avoid at all cost if you don't.

Friday, August 04, 2006

Risk, Return and the Markowitz Portfolio Theory

Harry M. Markowitz won the 1990 Nobel Prize for telling the world two fundamental truths about investment: "Higher risk, higher return" and "Don't put all your eggs in one basket". Much as I sounded as if he deserved the Novena Primary School Mathematics Competition Runner-up, I must point out that his findings were mathematically elegant. (I know you are saying "yeah right" but trust me, it's true, I was genuinely amazed by the beauty in its simplicity.)

Nevertheless, the important implications of his modern portfolio theory still hold true in today's investment arena.

To briefly summarize what was his theory all about, we need to assume that the markets are efficient. The efficient market hypothesis essentially assumes a lot of things that do not make sense but academics love them anyway. Just to mention a few, efficient market assumes that all investors are rational (well if you think monkeys are rational), zero transaction cost (hmmm if sell-side analysts are monkeys and work for bananas) and that information flows freely (monkeys talk to one another all the time and need not buy one another bananas for info) etc. These we all know are not true.

However, that is not the point, the point is once we assume markets are efficient, according to Markowitz the only way we can make more money is to

1) To take more risk (by investing in riskier assets)
2) To diversify (by investing into different asset classes which are not correlated)

This is graphically represented above in what is known as the Efficient Frontier. The Efficient Frontier represents the maximum return that can be achieved at a specific level of risk. If an investor wants to achieve a higher rate of return, she can invest in riskier assets, like equities or venture capital (This is the "Higher Risk, Higher Return" part). This can be easily visualized as shifting from one point (e.g. Bonds) to another point (e.g. Equities) on the right of the same Efficient Frontier.

Now she can also choose to invest in many different kinds of assets (commodities, real estate etc), hence not putting all the eggs in one basket. This will push out the Efficient Frontier (a parallel shift of the whole Efficient Frontier upwards), enabling the investor to reap more return for any given level of risk.

So as I said, elegant math that explained two truths about investment.

Wednesday, August 02, 2006

The Players

Know yourself, know your enemy and you can fight a hundred battles and win a hundred battles. This timeless quote from Sun Tze holds true for players in the stock market as well. (I also got a bit of ink lah!) Although a true value investor (see also value investing) would not worry about matters other than those that are related to the intrinsic value of the company, one must be mindful of the forces that move stock prices. This would allow us to buy a good company at cheaper prices and also help us determine when to take profits.

As a basic introduction, here is a (non-exhaustive) list of players in major markets

1) Institutional investors (mutual funds, pension funds, etc)
2) Hedge funds (Macro, long-short, long-only, arbitrage, quant)
3) Brokers (Investment banks, traders, investment arm)
4) Retail investors (rookies, day-traders, investors)

To give you flavour, for a moment let's think of Zouk as the market, then the discription becomes

1) The incumbents, always around, deep, skilful, in control
2) New kids on the block, funky, attention seeking and scoring big
3) The pimps, gd at managing relationships & taking commissions
4) Participating on the sidelines, usually at the losing end

Institutional investors continue to be the major class of investors in the world. They usually invest in benchmarks (like STI, S&P or Nikkei) and their investment activities revolve around their benchmarks as well. Hence on average they are the trend-followers rather than the trend-leaders. Of course there are the top fund managers who can identify trends way before everyone else. But when the majority follows a trend, they move markets big time.

Perhaps the most important takeaway is that hedge funds have become a major force in the markets. Hedge funds are usually small investment outfits that invest with radical strategies to make a lot of money with leverage. Hence the name "hedge fund" is actually a misnomer. Hedge funds take a lot of risk to produce their desired return. They are responsible for a lot of volatility in stock prices nowadays and they are increasing their asset under management, for better or worse.