This article is purely for discussion purpose and it is definitely not a stock tip.
I happened to read about a portfolio of quality Bursa stocks held by a value investor in a internet forum recently, I computed the return of this portfolio of stocks which has lasted for 10 and a half years. This portfolio consists of high quality big-caps stocks which are followed closely by fund managers and institutional investors. The stocks are; Petronas Dagangan, Nestle, Public Bank, Dutch Lady, Heineken Malaysia, LPI, Aeon Credit, and Carlsberg.
The portfolio returned an average of 362% over the last 10 and a half years as on 4th January 2019 as compared to the return of the broad index of 52% during the same period. The compounded annual return (CAR), CAR of the portfolio was a whopping 15.4%, close to 4 times the CAR of 4.1% of the broad index. Note that they were selling at fair prices at an average PE ratio of just 14 then, not long after the US Subprime Crisis.
But how do we define a high-quality company?
Ask professional investors what they take value investing to mean, and responses will likely be consistent; buying stocks at low Price/Earnings, Price/Book, Price/Cash flows, high dividend yield etc. But ask the same people what they think of a high-quality company is, one of the classics in i3investor from a “Pro” which is repeated again and again is as below,
[Posted by qqq3 > Jun 14, 2019 4:28 PM | Report Abuse
quality of a company is some thing u know it once u see it., its called experience.]
Though for the opinions of general informed public and true professionals will vary widely. Some refer to company having a high growth potential, good management, brand names, market leader of the industry and other qualitative attributes, etc. These are important qualitative attributes of a high- quality company. However, they are all subjective and opinions vary widely.
Here I quantify those qualitative attributes to three major metrics; strong and predictable cash generation; sustainably high returns on capital; and high growth opportunities. Each of these financial traits is attractive at its own right, and when they are combined, they are extremely powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.
Let us take Panasonic Manufacturing Malaysia Berhad, Panamy as an example.
Strong and predictable cash flows
Table 1 below shows Panamy generates consistently on average RM107.5m of cash from its operations in the last 5 years until 31 March 2019. After spending about 36% on average on capital expenses, it yields an average free cash flows, FCF, of RM70.2m a year, or RM1.16 per share. From the FCF, it has distributed a total of RM8.72 dividend for the last 5 years and the rest retained in its balance sheet. In year 2019, dividend was RM2.26 per share. Shareholders can spend it, reinvest it in Panamy, or divesify to invest in other quality stocks.Panamy is truly a cash generating machine.
Table 1: Cash flows of Panamy
It is noted that the excellent cash flows for Panamy were generated internally without having to borrow any money, nor issue any new shares. That is because it has sustainable high return on capital from its operations.
Sustainable high return on capitals
Table 2 below shows the high return on capitals of the business of Panamy. Return on equity has been double digit averaging about 15%. Taking away the non-operating cash of over RM600m, the return on invested capital, ROIC are consistently in three-digit number.
Table 2: Return on capital
The high ROIC is basically due to the fast turnover of its inventories
and the bargaining power of the company in shorter credit term to
customers and longer credit term to its suppliers. For example, in 2019,
it took just 21 days to turn its inventories into goods sold, 38 days
to collect credit due from customers, and 72 days to pay its suppliers
and creditors, resulting a cash turnover period of -14 days. It means
the company doesn’t require any working capital for its business but
just capital expenses. What a great business!
With the high return on capitals and excellent cash flows, the company has spent about 36% of its cash flows from operations a year for capital expenses for growth in the last 5 years.
Growth
In the last twelve years, revenue of Panamy grew at a reasonable compounded annual growth rate, CAGR of 6.3% from RM541m to RM1.13 billion in 2019. Its operating income grew at a much faster pace of 11.7% from RM34.4m to RM130m while net profit grew by 7.1%. The growth is decent but not fantastic. It is noted that the growth is all from internally generated funds. Table 3 below shows the financial performance of Panamy in the last 13 years from 2007 to 2019.
Table 3: Financial performance of Panamy
Panamy’s business generates consistent high cash flows from its high return of its capital employed. A great portion of its cash flows are distributed to shareholders with remaining reinvested for growth, which in return obtain high return on the reinvested capital and beget more cash flows for the company. Shareholders have been enjoying high dividend from investing in the company. Besides the high dividend, its share price has also risen by 221% in the last 10 years from RM11.92 to RM38.20 now as shown in the Figure below, or a CAGR of 12.4%. It is hence considered as a quality company, in my opinion. Of course its future growth prospect is more important.
Valuation of quality companies
In quality investing, as in any investment strategy, the risk of overpayment exists, but far less than one might think. At a glance, the price-earnings multiples of a quality business relative to its growth, in Panamy’s case at 22 at the present price of RM38.20, can look exaggerated. However, quality companies often tend to exceed estimates, meeting or beating forecasts far more frequently than poor quality companies.
Many investors might find some high-quality companies but would like to buy them when they are selling at cheaper prices later. The problem is that the day seldom comes: if a company keeps delivering operationally, its relative valuation multiple rarely contracts.
Look at Nestle Malaysia, how its share price continues to rise from RM27 ten years ago to RM148 as on 4th June 2019 now, or for a CAR of 17%. Share prices, even when at seemingly high valuation multiples, often fail to fully capture the combination of predictability and value creation in delivering earnings growth such companies offer in the long term. However, do note that the mid PE ratio 10 years ago for Nestle was about 20, certainly not dirt cheap but also inexpensive. Nestle now is selling at a PE ratio of 52, certainly not cheap now. In my opinion, investors who continue to hold Nestle at this price will obtain satisfactory return over the long-term but will not be an extra-ordinary return.
Investing in quality stocks for the long term when they are selling at reasonable price is certainly a good thing to do especially for those who have no time nor any knowledge in investing in the stock market. However, it doesn’t mean one must buy quality stock at any price. That would be foolish.
I have written a eBook on personal finance and investing. Among the topics discussed includes how to determine if a stock is a quality stock, qualitatively as well as quantitatively. It also discusses some valuation techniques to determine if a quality stock is selling at a reasonable price. To be successful in investing, these two things must come together.
If you are interested in my eBook, you can email me at ckc13invest@gmail.com
This is given free.
KC Chong
I happened to read about a portfolio of quality Bursa stocks held by a value investor in a internet forum recently, I computed the return of this portfolio of stocks which has lasted for 10 and a half years. This portfolio consists of high quality big-caps stocks which are followed closely by fund managers and institutional investors. The stocks are; Petronas Dagangan, Nestle, Public Bank, Dutch Lady, Heineken Malaysia, LPI, Aeon Credit, and Carlsberg.
The portfolio returned an average of 362% over the last 10 and a half years as on 4th January 2019 as compared to the return of the broad index of 52% during the same period. The compounded annual return (CAR), CAR of the portfolio was a whopping 15.4%, close to 4 times the CAR of 4.1% of the broad index. Note that they were selling at fair prices at an average PE ratio of just 14 then, not long after the US Subprime Crisis.
But how do we define a high-quality company?
Ask professional investors what they take value investing to mean, and responses will likely be consistent; buying stocks at low Price/Earnings, Price/Book, Price/Cash flows, high dividend yield etc. But ask the same people what they think of a high-quality company is, one of the classics in i3investor from a “Pro” which is repeated again and again is as below,
[Posted by qqq3 > Jun 14, 2019 4:28 PM | Report Abuse
quality of a company is some thing u know it once u see it., its called experience.]
Though for the opinions of general informed public and true professionals will vary widely. Some refer to company having a high growth potential, good management, brand names, market leader of the industry and other qualitative attributes, etc. These are important qualitative attributes of a high- quality company. However, they are all subjective and opinions vary widely.
Here I quantify those qualitative attributes to three major metrics; strong and predictable cash generation; sustainably high returns on capital; and high growth opportunities. Each of these financial traits is attractive at its own right, and when they are combined, they are extremely powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.
Let us take Panasonic Manufacturing Malaysia Berhad, Panamy as an example.
Strong and predictable cash flows
Table 1 below shows Panamy generates consistently on average RM107.5m of cash from its operations in the last 5 years until 31 March 2019. After spending about 36% on average on capital expenses, it yields an average free cash flows, FCF, of RM70.2m a year, or RM1.16 per share. From the FCF, it has distributed a total of RM8.72 dividend for the last 5 years and the rest retained in its balance sheet. In year 2019, dividend was RM2.26 per share. Shareholders can spend it, reinvest it in Panamy, or divesify to invest in other quality stocks.Panamy is truly a cash generating machine.
Table 1: Cash flows of Panamy
|
Year |
2019
|
2018
|
2017
|
2016
|
2015
|
5-yrAv
|
|
Net income |
105752
|
131025
|
127118
|
146900
|
99538
|
122067
|
|
CFFO |
120642
|
127200
|
92268
|
116710
|
91612
|
109686
|
|
Capex |
-54386
|
-53522
|
-43615
|
-30491
|
-15340
|
-39471
|
|
FCF |
66256
|
73678
|
48653
|
86219
|
76272
|
70216
|
|
FCF/share, sen |
109.1
|
121.3
|
80.1
|
141.9
|
125.6
|
116
|
It is noted that the excellent cash flows for Panamy were generated internally without having to borrow any money, nor issue any new shares. That is because it has sustainable high return on capital from its operations.
Sustainable high return on capitals
Table 2 below shows the high return on capitals of the business of Panamy. Return on equity has been double digit averaging about 15%. Taking away the non-operating cash of over RM600m, the return on invested capital, ROIC are consistently in three-digit number.
Table 2: Return on capital
|
Year |
2019
|
2018
|
2017
|
2016
|
2015
|
|
Return of equity, ROE |
12.6%
|
14.9%
|
15.5%
|
18.9%
|
13.9%
|
|
Return on invested Capitals |
91%
|
122%
|
147%
|
427%
|
871%
|
With the high return on capitals and excellent cash flows, the company has spent about 36% of its cash flows from operations a year for capital expenses for growth in the last 5 years.
Growth
In the last twelve years, revenue of Panamy grew at a reasonable compounded annual growth rate, CAGR of 6.3% from RM541m to RM1.13 billion in 2019. Its operating income grew at a much faster pace of 11.7% from RM34.4m to RM130m while net profit grew by 7.1%. The growth is decent but not fantastic. It is noted that the growth is all from internally generated funds. Table 3 below shows the financial performance of Panamy in the last 13 years from 2007 to 2019.
Table 3: Financial performance of Panamy
Panamy’s business generates consistent high cash flows from its high return of its capital employed. A great portion of its cash flows are distributed to shareholders with remaining reinvested for growth, which in return obtain high return on the reinvested capital and beget more cash flows for the company. Shareholders have been enjoying high dividend from investing in the company. Besides the high dividend, its share price has also risen by 221% in the last 10 years from RM11.92 to RM38.20 now as shown in the Figure below, or a CAGR of 12.4%. It is hence considered as a quality company, in my opinion. Of course its future growth prospect is more important.
Valuation of quality companies
In quality investing, as in any investment strategy, the risk of overpayment exists, but far less than one might think. At a glance, the price-earnings multiples of a quality business relative to its growth, in Panamy’s case at 22 at the present price of RM38.20, can look exaggerated. However, quality companies often tend to exceed estimates, meeting or beating forecasts far more frequently than poor quality companies.
Many investors might find some high-quality companies but would like to buy them when they are selling at cheaper prices later. The problem is that the day seldom comes: if a company keeps delivering operationally, its relative valuation multiple rarely contracts.
Look at Nestle Malaysia, how its share price continues to rise from RM27 ten years ago to RM148 as on 4th June 2019 now, or for a CAR of 17%. Share prices, even when at seemingly high valuation multiples, often fail to fully capture the combination of predictability and value creation in delivering earnings growth such companies offer in the long term. However, do note that the mid PE ratio 10 years ago for Nestle was about 20, certainly not dirt cheap but also inexpensive. Nestle now is selling at a PE ratio of 52, certainly not cheap now. In my opinion, investors who continue to hold Nestle at this price will obtain satisfactory return over the long-term but will not be an extra-ordinary return.
Investing in quality stocks for the long term when they are selling at reasonable price is certainly a good thing to do especially for those who have no time nor any knowledge in investing in the stock market. However, it doesn’t mean one must buy quality stock at any price. That would be foolish.
I have written a eBook on personal finance and investing. Among the topics discussed includes how to determine if a stock is a quality stock, qualitatively as well as quantitatively. It also discusses some valuation techniques to determine if a quality stock is selling at a reasonable price. To be successful in investing, these two things must come together.
If you are interested in my eBook, you can email me at ckc13invest@gmail.com
This is given free.
KC Chong
https://klse.i3investor.com/blogs/kcchongnz/210972.jsp
