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.

Near Monopoly Part 2

To illustrate Pt 4 and 5 of the previous post, we look at a Singapore company: SMRT. As with railroads in other countries, SMRT is a kind of natural monopoly bcos the capital outlay is so intensive, no competitor can come in and build a similar infrastructure just for the sake of competition. Even our beloved Government tried that and failed when they gave the North East line to another operator only to realize it doesn’t work.

So SMRT is in a good position to basically do whatever they want to enjoy supernormal profits.

First, they raise prices like nobody’s business. Well it’s subjected to approval from the LTA but heck, LTA always approves anyways. So the Singaporean passengers comprain and comprain like there’s no tomorrow. Actually in my opinion, it helped bcos SMRT became less aggressive somewhat after seeing the social repercussions. The truth is, Singapore train fares are probably still quite low at 70c for 1 station compared to global average of roughly US$1. So prepare for MORE fare hikes to come.

And after raising fares, the quality of service actually drops. That’s probably the unforgivable action. Trains take more than 10 min to arrive at non-peak hours and they frequently break down with minimal repercussions. Talk about 1st World Service!

Nonetheless, the shareholder benefits. SMRT shareholders have seen net profits grown S$100mn to S$160mn over the past 10 years. Dividends more than doubled from 3c to 7c. If you have bought SMRT at 60c (roughly the IPO price), dividends over the past 10 yrs would have reaped 40c. Not to mention the price today is $1.6.

With increasing population and real estate potential from re-developing its stations, SMRT’s future growth may not slow down unlike some other Singapore monopolies like SPH and Singpost. There is also the wildcard of whether the other future lines (Circle, Downtown etc) will be given to SMRT to manage as well. Again since most of the capex is done by the Government, it's a free lunch for SMRT and its shareholders.

However, it is likely that the company will continue to squeeze the commuters by providing ever declining quality of service and at the same time raising fares whenever the opportunity arises. Hence it is prudent for every commuter to become an SMRT shareholder.

As a shareholder, besides the dividends and capital gain, you can go and eat free food at the AGM and screw the management by asking tough questions. Hopefully they wake up their ideas and start to look at BOTH profits and services.

Near Monopoly

Companies with dominant global share are usually capable of generating supernormal profits. Sadly, in Singapore, such companies are hard to come by and hence this important factor is rarely looked at and discussed.

As Economics 101 would tell us, monopoly or near monopoly creates many conditions that is ideal for the market leader. These includes

1. Huge economies of scale – hence able to produce at a lower cost than most competitors

2. Bargaining power with clients and suppliers – to the extent of pricing out other competitors or ousting them in other ways

3. Advantage in capital outlay – a market leader does not need to spend as much as a competitor when increasing capacity bcos it can always leverage a lot on its existing structure (including distribution, sales and marketing etc)

4. As a result of stifling competition, the market leader now has pricing power. Basically it can price its product or services at any rate and customers will need to accept as there is no alternative

5. Reduction in cost of operations, and hence leading to a reduction in quality. The market leader now can reduce its cost of operations – including perhaps reducing the amount of input material cost or cutting sales force. This leads to reduction in quality of product or service

I guess the whole Singapore society is an apt reflection of monopoly works. Prices are ever rising yet quality of product or service keeps dropping. As consumers, Singaporeans keep suffering. Hence it is important for us to become shareholders as well, and so more or less offset the shit thrown at us as consumers.

*Sigh*, that's life in Singapore. Tomorrow will be better. Or so we hope.

Anyways, as an example to illustrate Pt 1, 2 and 3, we have HP laser printers. HP has a dominant share in the global laser printer market. Around 60% market share. As a result of this, they have huge economies of scale. They can produce laser printers and more importantly, the ink cartridges, at a much lower cost than all other competitors. However there is no need to sell the cartridges at a lower price than competition bcos they enjoy a good brand name. But if they wanted to, they could easier crush all other competitors by selling their cartridges at a much lower price.

Since they are the No.1 leader, they can always demand the best shelf space in electronic stores, or lower distributor margins, or bargain for lower prices with their parts supplier (those who supply the various small components inside the printer).

Of course, they can build new production lines and bring in new capacity at a much lower cost than all others. So how can anyone compete at all? Despite this, the never-give-up Korean superpower Samsung is fighting hard to break HP’s monopoly. We shall see if they have the same success with LCD TVs.

Next post, we look at a Singapore company on Point 4 and 5.

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

Companies that shouldn't exist

The market is efficient and smart, but only to the point of the average smartness of all its investors. Hence it allows companies that spectacularly generate low or even negative return on capital to exist for very long periods of time.

The No.1 ranking company that achieve this tremendous feat would probably be Chartered Semiconductors, our beloved high tech foundry.

Over the past decade, the company had lost over a billion dollars culmulatively, burnt two billon SGD of cash and generated a spectacular ROE of negative 6%. It has never paid a cash dividend in its entire existence and have asked for money countless times.

Considering that cost of capital is around 6% (see previous post), Chartered failed to even come close. In fact, Chartered helped investors LOSE 6% every year. Yet the market cap of Chartered had been around S$2bn for the good part of the past 10 yrs. (its peak was a whopping S$7bn during the IT bubble and trough a miserable S$300mn during the Lehman shock.) Why would such companies exist in a rational, efficient world?

Well the stock market is just one aspect of the economy I guess. Chartered provides tens of thousands of jobs considering all the peripheral companies that it supports, we cannot just let it go down right? So we did the next best thing, we sold it! And thank goodness, Chartered will be delisted.

Why has a company like Chartered lingered around for so long? Well market participants always had hope and greed and of course Chartered did serve some purpose for punters. Back in the IT bubble, it was so clear that Chartered would be a STAR. It made chips for goodness sake. And chips are what make IT possible. so that was the eternal hope. Even when the company started burning REAL cash for Hungry Ghost festival every year, investors held hope. It's biggest shareholder, Temasek, never gave up. Well until now, that is.

Here lies the new insight I have about efficient markets. Markets are efficient in the short run, ie 1-2 yrs where almost all market participants share similar thought horizon and are able to price stocks very efficiently within this time frame. And markets are efficient in the very long run, ie more than 10 yrs - companies that ultimately shouldn't exist would go, like GM, like some airlines, and perhaps Chartered. And of course, Great companies will rise through the ranks and become behemoths and rule the world, like Walmart, Toyota and Nestle etc.

Cost of Capital

This post is edited in 2016.

We are back to talking about something dry after a long, long hiatus. Ok Cost of Capital.

Basically, capital is not free, it comes at a cost.

Why is there such a cost? Well basically the person providing the capital needs to earn a return. If not, he might as well chuck it under his pillow right?

So the question is how much return does he want?

Well, the lowest return he can get without any risk of his original amt being reduced is 3% or so. That is if he buys government bonds. So the cost of capital cannot go below 3%.

Capital actually comes in two forms: debt and equity. Let's talk about the cost of debt first, bcos it's easier.

Debt
Say you want to start a company today and need money, so you go to a bank and ask for a SME loan. Depending on the nature of your business, your bargaining ability, the desperation of the loan officer, your interest on the loan should be around 6-10%, which is pretty high. Well that's bcos it's SME, may go any time one. So the bank needs some buffer. If a big Fortune 500 firm issues a bond, they can probably get US$100mn with interest rate of 4+% or so.

So the cost of debt is just that: 4% to maybe 6% for most large cap companies. In 2016, with negative interest rate dominating a lot of sovereign bonds, the long term cost of debt has come down to 2-6% for corporates.

Equity
Traditionally it has been thought that cost of equity should be higher than debt bcos the equity provider gets to participate in the upside (when the profit grows, stock price rises) but the debt owner will always only receive the fixed interest. So cost of equity will at least be 6% or more. In the 1950s or maybe 60s, academics tackled this question in a big way and came out with a huge model called the CAPM model. This is huge and Nobel prizes are given and economists became gods. For those interested, you can go wiki it or something.

Basically the idea is that cost of equity can be expressed in an equation like

Cost of equity = risk free rate + equity risk premium

The equity risk premium part can be further broken down into super complicated stuff like beta and expected market return which are too mind-boggling for our purposes here so it suffice to say that this equity risk premium should be a no. to compensate equity investors for the risk they take and make the total cost of equity higher than cost of debt.

Historically, cost of equity is about 8-10% for most large cap companies.

So the equity risk premium is about 5-7% (bcos risk free rate, which is usually long term government bond yield is about 3%)

Combining the two, you get something called the WACC (for weighted average cost of capital), and this is the cost of capital for a company. This no. usually ranges from 6-8% judging by the no.s given above.

It is said that companies should earn more than its cost of capital to justify its existence. So meaning the co. should have a return on capital of at least 6-8%. Capital meaning debt + equity, or roughly speaking total asset of the company (not exactly the same thing but close). If the co. has no debt, it means that the return on equity (the famous ROE), should jolly well be above 8-10%, ie above the cost of equity.

If a company cannot generate this return, then investors should really pull out all the funds and invest in others that can. However, in real life, that is not always the case, as we shall explore in the next post.

What's Right with Buy-and-Hold?

So Buy-and-Hold has its flaws, but the alternative, which is trading is not much better. Empirically, trading has not help generated wealth. But before we come to some conclusion, let's look at the usual Pros with regard to Buy-and-Hold.

Pros

1. Missing out the 10 biggest days in positive movement

Studies have shown that if you subtract the returns of the 10 biggest positive gain days in the past 20 yrs, your long term average annual return drops something like from 8%pa to 4%pa. This is major bcos suddenly you might as well go and buy 30 Yr Singapore Govt bonds and that could have given you close to 4%pa, without all the risks associated with stock market. Since we cannot predict which days will be the biggest positive gain days in advance, value investors argue that we should always buy and hold to reap the full benefits.

2. Transaction cost

This has come down over the years but still constitute 0.5% or more to most retail investors. Considering in Singapore where the minimal brokerage cost is S$20 per trade, you need to do a S$8,000 trade so that you can get the buy and sell costs to be 0.5% of your trade. Sadly it can only go as low as 0.25% bcos after that, the brokers charge based on the size of your trade. So let's work with 0.5%. Most retail investors would probably do more than 1 buy-sell trade per year, let's say they do 2. We know that average annual market return is 8% and two trade incur transaction costs of 1%. Congrats, you just gave your brokers a 12% commission. Every year. So Buy-and-Hold pls, save the transaction cost.

3. Dividends

Globally dividend yield usually ranges from 2-4% and in extreme times, you see dividend yield of a market going to 6-7%, like the STI in 2008. Albeit it's a lagging yield bcos the data is always late to factor in a drop in dividend going forward. Anyhow, the point is, dividend is a huge part of return. Since we all know that average market return for investment is only 8%, dividends can constitute 25-50% of this market return. It does make sense to focus a lot on dividend stocks. And needless to say, to get dividends, you can't just trade, you need to buy-and-hold.

4. Missing out the full growth

This will be the most compelling argument. Trust me.

If you have bought a Great Company, not just Good but Great with a capital G, then there is never a right time to sell bcos the company simply grows exponentially and overwhelms everything! Some of Berkshire's companies would illustrate this very well. I will just highlight See's Candy and Coke. Buffett bought over the whole of See's Candy for USD 25mn in 1972. Today See's generate pre-tax earnings of over USD 1bn, if See's is a listed co. the market cap would be close to USD 20bn. So that's close to a 1,000 fold return. Mind you, that's 100,000% return. If you sold for 100% profit in 1973, you just made the biggest mistake of your life.

Coke tells the same story. Berkshire bought 8% of Coke for USD 1bn in 1988, today the same stake is worth USD 10bn and Coke's pre-tax earnings is USD 7bn, of which Berkshire is entitled USD 600mn (on paper). In another 10 yrs, the profits entitled to Berkshire would be more than what Berkshire paid for and this current ten bagger will become a 20 bagger or even more. So is there ever a right time to sell Coke?

Sadly, most retail investors never get to enjoy this kind of thrill bcos a 20% profit in 2 weeks is already better than sex.

Conclusion

Again in investing, there are no hard and fast rules, most of the time buy-and-hold makes sense, but there are times that they do not, some times you can take some profit here and there during those periods. However, to trade in and out every few weeks or days and try to beat buy-and-hold is a tall order. Much taller than most people would like to think so. Not to mention the effort needed to do those weekly trades! So run through the pros and cons again, when you are tempted to trade!

What's Wrong with Buy-and-Hold?

This is another topic that has been debated left-right-centre since... Geez, Adam and Eve I guess. Let's just go through the usual pros and cons. I will start with the Cons.

Cons

1. Doesn't help to make money

This has been highlighted various times in the papers. Someone who bought an index, say the S&P500 and held for the past 10 years would have made zero return. In some markets, you could have bought-and-hold for the last 20 years and still lost money. The best example being Japan. Buy-and-hold at any point over the past 20 years would have made negative return! So to hell with Buy-and-Hold right?

2. What about locking in profits?

If a stock has risen 100%, and knowing that stocks on average gives only 8%pa, this stock has already given you roughly 10 yrs worth of return, isn't it a good idea to lock in the profits? Especially if the stock intrinsic value is not going to grow by that much over time - meaning that it's grossly overvalued. We should sell when things are grossly overvalued, right?

3. There is no time.

Buy-and-hold takes a long time to give you a good return ie average market return of 8%pa. However, time is a luxury that not everyone has, especially if you are 40 and above. You need a substantial retirement nest egg in 15 yrs assuming you retire at 55. Although retirement age is 62, most people don't get to stay employed until that age unless you are a civil servant, or self-employed. And increasingly, the career lifespan is shortening, look around you, do you see a lot of your colleagues in their 50s? So how do you buy-and-hold in 10 or 15 years? Incidentally, if you bought the STI index in Dec 99 at 2,600 points, you just managed to claw back your capital as the STI today is, well, at 2,600 points! 0%pa after 10 years, that's great isn't it?

So Buy-and-Hold sucks, what should we do?

Well you trade. You buy the STI when it was at 1,200 in Sep 2000, Hold until Sep 2007 and sell at the peak of more than 3,000. Buy back when it dropped to a low at 1,500 in Jan 2009 and sell now at 2,600. You would have make 500% gain over the past 10 yrs, that's roughly 50%pa.

Haha, well this can only be done on hindsight. Most traders lose their pants trading bcos their emotions get to them. Even if they bought at 1,200, they would have sold when it reached 2,000. Then hastily buy more when it reaches 3,000 and then got stuck when it collapsed, etc. Well you know the story, don't you.

Trading works when you have a good trading system and you adhere to it. 100%. If you do that, you can probably make an average return of 4-6%pa after transaction cost. Of course, legendary traders make a lot more than a meagre 4-6%pa. So we should strive to be like them! Then value investors will bring out Warren Buffett, who made 24%pa for 50 yrs and grew USD 1mn to USD 60 BILLON. So better argue based on average returns, not the legends' rate of returns.

In reality, most retail traders lose money trading. We are not even talking about market return of 8%pa here. Next post, we look at what's right with Buy-and-Hold.

The ultimate bet

This post is related to the last one regarding probabilities and payoff and how we should bet.

We often hear about people betting their life savings of $100k on the next property of say $500k, hoping for that 20% rise before TOP and make $100k return (with a capital base of $100k). Lets see how this works in that matrix thingy we used in the previous post:

Let's give the benefit of doubt and say this guy has 70% chance of making $100k, he has read the property market well, the cycle is turning, the stars are aligned. However, again in life, since nothing is 100% one, we have to think that he also has a 30% downside whereby he will lose $250k (ppty of $500k goes down by $100k, mortgage $130k, legal fees $20k all add up to $250k)

Probability payoff
0.3 -250k -75k
0.7 100k 70k
Expected return -5k

Now we see that the expected return is negative. Even if we tweak the no.s here and there, which I did, the expected return is not high. You can probably get to expected return of $80k - which is good if you use $100k as the base. But in reality the base is $500k, bcos the guy borrowed $400k from the bank. So you risked a life of perpetual debt for $80k, is it worth it?

In real life, and not just paper math, if the 30% probability becomes reality, this guy is stuck with a $500k 30-yr mortgage on a house worth significantly lesser, he may have cashflow problem and need to sell out some time in the next 30 yrs, or declare bankruptcy. As we know it, his life is over. Well at least financially that is. He will never achieved the much coveted financial freedom, a nice cosy retirement nest egg and the kind of crap Robert Kiyosaki likes to preach.

Anothe way to look at it, we can think of such bets as extreme as this Russian Roulette game:

1 shot of out six has a real bullet.

If you win, you get paid $5mn, enough for a lifetime. (Well at least for me, I dunno about you though)

If you lose you die.

Odds are in your favour: ok let's make it even better, we have a revolver that can house 20 shots.
So only 1 in 20 chance you will die.

19 in 20 chance you never have to worry about money in life.

Will you play?

Betting when the downside is something we cannot afford to happen is not a good way to bet. Think about this when you are faced with such choices.

Probability and Payout

This is something that relates to the Kelly Formula but at a much more simplistic level.

Basically, it all started when some friend of mine had the idea that if we are 80% sure of a 10% upside, we should be punting big on this event?

Eg. we heard a rumour that the CEO of TSMC saying he wants to buy Chartered for $2.20 (Today closing price $2.00) from the secretary of the CEO of TSMC and he will announce it tomorrow. How should you bet?

Mathmatically, this event can be illustrated with the matrix below.

Probability Payout
0.8 10 8%
0.2 -20 -4%
Expected return 4%

In the first scenario, there is a 80% chance you earn 10% and in the 2nd one 20% chance you lose 20% bcos say for some reason, he did not announce it the day after, or something unexpected happens. In life, nothing is 100%, even if you are the TSMC CEO yourself, you cannot say for sure if you can make the announcement as planned. You might get murdered, or something else etc, Anyways, as such is the case, the expected return is actually about 4%, which is, well, lower than market return of about 5-8%pa.

My initial thought is that we cannot punt this kind of event to help us make big bucks. Given the inherent unreliability of a rumour, the low expected return, it is not exactly a good way to maximize wealth. Of course we can always tweak those probability and payoff to get a good expected return, but using logic and rationality, it is difficult to get a good expected return of more than 15%.

In value investing, I think the matrix looks like this:

Probability Payout
0.4 -30 -12%
0.6 50 30%
Expected return 18%

There is a 40% chance you will lose 30% of your money, but a 60% you make 50% (remember margin of safety and other safeguard put in place?) Your expected return is 18%. If you make enough of these during a lifetime - you are a clear winner.

The caveats here are:

1) your analysis must be quite accurate, ie the intrinsic value is really 50% higher than current price

2) the timeline here is long, it may take 3 years to realized this 18%, which means 6%pa

You might think this is just bcos I am promoting value investing. But if you play around with the probability and payoff you can still get 10+% payout on average, which would translate to only 2-3%pa but still it's positive number.

Back to the TSMC case, you can argue that the 4% when translate to annual return becomes 1200%pa. Spectacular! However the logic would be that you won't get to hear a rumour about a takeover 300 days a year... So looking at the absolute expected return no. regardless of the timeline becomes important. And if you play around with the probability and payoff for this, you do get negative numbers.

So with this in mind, hopefully you can do this simple exercise with your next stock buying and practise more value investing rather than punting!