Investment Reflections for 2018

This year would mark the 6th year of investing in equities. The journey was met with unexpected challenges and positive surprises.

Through investing, I came to know many beautiful souls.

Through investing, I found my gift of sharing.

Through investing, I formed a community.

Through investing, I was able to give back to the world.

This year would mark the  6th year of investing in equities. Before I start, I’d like to share my recent travel.

One of the reasons why I love traveling, it allows me to draw comparisons between my reality and other people’s reality. Last night, I returned from Vietnam. We traveled to Mũi Né and Ho Chi Minh City. Somehow, I became sensitive towards the economic progress of the nation and how poverty still exists in some parts of the city. It pains my heart to see some of it happening right before my eyes. Then, immediately, my mind brought me back to the moment where my friend Paul shared about his vision of establishing an orphanage in Thailand. I got me thinking a lot about my life. I consider myself to be normal but I am blessed to be living with proper conditions. I am blessed to receive an education which allows me to unleash my potential in the field of investing.

But many people are not like me. Or like you.

If we were born in an impoverished place, our lives would be so different.

Imagine, when you inject time and resources into proper schools, you’ll allow people to be nurtured towards the right direction. These people would then grow up and contribute back to the society, creating a huge ripple effect forever.

All of us are given a life. We may not know what our purpose is but whatever we are gifted, we must let it go to waste. One life, don’t waste it. Give and contribute to the best of our abilities. Hopefully, I can join my friend Paul to do something together.

This trip invigorated my sense of purpose. I feel, with my knowledge, I can help others grow their portfolio and inculcate a sense of giving back. There is a limit to what I can do but there is no limit to what many united hearts can do.

This ties back to the reason why I wanted to start my own community and promote investing in my social circles and beyond.

Lesson #1 – High-Quality Companies

I’ve spent a considerable amount of time analyzing turnarounds and cyclical in the past. I met with some successes and some failures. Johnson Outdoors, Systemax and Hi-P International were companies I identified using my proprietary process. I also expected InnoTek to turn around and grow its earnings. After recovering its earnings, the share price remained flat and it refused to move up. I understood it immediately.

InnoTek may not be a high-quality business because it does precision metal component and tooling. It is a largely commoditized business because someone could potentially enter into this industry and do something similar to them. When you have a commoditized product/service, you always risk having a competitor stealing away their business by using price as a weapon. This is why I will avoid companies with low gross profit margin, it shows competition is lurking around.

Hence, low-quality businesses will remain cheap.

Go for companies with proprietary know-how or their products/services require a high level of knowledge and expertise. How dependent are their customers? If the customers are so dependent on the company, it shows clear dominance and high customers retention rate. Some examples are Adobe and Microsoft.

An acid test is this, ask yourself, “If I were to invest over $300 million in a new startup to compete with company X. Is it possible to dent or destroy their business?”

OR

“If I hire the same type of people, invest and research into the same type of product/service, is it possible to recreate the company or the brand?“

If your answer is no, then the business is unique and differentiated.

Please don’t ever invest in a business where anyone can start and compete with you, the business not protected at all. This is why they are cheap. Competition drives earnings down. Credits to my friend JC who shared this with me.

It’s not just this. You need growth in your business. Go for companies with a large addressable market with tailwinds. Also, don’t waste your time on companies that are not going to matter over the long run. Would you spend time analysing a company where you can hold for 2 – 3 years then the growth stops… or analyse a company where you can hold for 5 – 8 years? The latter one would give you better ROI for your time spent.

I’ve revamped my portfolio to consist of high-quality companies and I feel very happy to know they are able to grow over the long term. Most companies run up, then fall back and fade away. You won’t like to invest in those type of companies. Focus on a few high-quality ideas and you’re going to do very well in your life.

Lesson #2 – Exponential & Operational Leverage

I like this book called Exponential Organisations. My friend Kelvin bought it and shared the content. I was mind blown!

This is going to move our economy forward and it is also one of the reasons why I advocate companies with exponential characteristics.

The key is to look for companies where… it can earn incremental revenue WITHOUT incremental costs. You can look at my articles by clicking here (ops lev) and here (exponential).

In essence, having exponential growth potential and operational leverage allows a company to grow easier as it scales up. Think about Visa and Facebook. In the early days, it was so hard for them to grow. But once they’ve reached beyond critical mass, growth becomes very easy.

How hard is it for Visa to get a new merchant? Very easy. Many merchants queue up for a Visa terminal and in fact, some are even on the waiting list. Visa just needs to get banks to do the jobs of issuing terminals to the merchants. Once it’s installed, Visa would earn a fixed percentage of all the Visa transactions performed. What is the tailwind? More cashless transactions in the next few years.

It is the same for Facebook, more and more advertisers are understanding the power of Instagram and Facebook marketing. When an advertisement is placed out, it is automatic. So to speak, Facebook does not need to hire more staff that is proportionate to the number of advertisements being placed out. Perhaps, Facebook needs to hire 5% more staff when the number of advertisements increased by 100- 200% or so.

It’s just an analogy but you’ll get it. Both businesses are scalable.

Lesson #3 – Don’t Do Charity

I fell in love with a company and the love made me blind to its rising trade receivables problem. There are many healthy looking companies with growth but we need to be sure that the accounting earnings are able to translate to cash flow to pay the expenses.

What are trade receivables? It is money to be collected from your customers.

If there is any delay in the collection, it means the company may need to borrow money to finance its operations or pay its salaries.

Think about this… you can do a job for $1 million in revenue and you incurred $500,000 in expenses. If this $1 million in revenue is paid 6 months later, you need to find fundings to pay for your operations for 6 months while waiting for the money to come in. It shows an inefficient business model. It also means the business requires a lot of working capital to standby.

Any business that is unable to collect its trade receivables on time or needs to extend long collection period to its customers… is bad business. The worst is when your customers are unable to pay up after many months, then your trade receivables become a bad debt to be written off. Essentially, you’re doing a job and you’re not being paid for it. It adds serious pressure and investors don’t show mercy to such company.

The share price would drop a lot.

That’s charity. Rising trade receivables increases the likelihood of “charity”. Monitor the trade receivables diligently.

Check my article out on Million Stars Holding.

Lesson #4 – Discipline in Valuations

“In the Bible, it says that love covers a multitude of sins. Well, in the investing field, price covers a multitude of mistakes. For human beings, there is no substitute for love. For investing, there is no substitute for paying the right price – absolutely none.”

– Arnold Van Den Berg, Outstanding Investor Digest, April 2004

Is there a case where your company reported high profits yet the share price comes down? Absolutely, this happens when the price multiple declines. To understand what I mean, read this.

If you want to invest in a company to make 2 – 6x over the next few years, you need to understand most of the stock returns come from price multiple re-rating.

Let me elaborate, if you are able to buy a good-quality business at EV/EBIT 10x and it moves up to EV/EBIT 20x, you would make two times your money without any earnings growth.

Similarity, you could buy something at EV/EBIT 20x but once the price multiple falls to EV/EBIT 10x, you’d lose 50% of your original amount.

(source: 100 Baggers)

Think about that. Earnings went up 25-fold, but thanks to the market putting a bigger multiple on those earnings, the stock went up 125-fold. Price multiple re-rating and earnings growth are “twin engines” of stock performance. The secret of wealth creation becomes from price multiple expansion and strong earnings growth.

But if you buy a company with a high price multiple, then you can rely on earnings growth as the sole engine. Earnings growth is important but more money could be made via re-rating.

This year, I bought a company that was trading at EV/EBIT 10x, within 1 – 2 months, it shot up to approx. 30x. I made 300% on it.

If I buy something at EV/EBIT 30x and the EBIT grew by 30% next year, it means the forward EV/EBIT is 23x. Take 30 / 1.3 = 23.1x.

However, if the market decides to value it at 20x, you’re going to lose 13.4%.

(20/23.1) -1 = 13.4%  You see how despite growth in EBIT, the change in price-multiple contraction would cause the share price to drop?

Protect yourself by being very disciplined in your purchasing price-multiple. A common mistake I see in other investors and myself is, we pay high prices for quality stocks because we have the fear of missing out. The only way to make an enormous amount of returns is to find growth companies at very reasonable prices. One example is SGX-listed Best World International.

As I am typing, Facebook’s EV/EBIT is 12.88x. I am a shareholder.

Conclusion

Overall, I feel happy to have a framework to move forward with my wealth creation process.

I am ready to face 2019! To build a greater community and beyond!