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Tea with Mike: Approach to stock selection

Sunday, September 1, 2013

There are many ways of selecting stocks. Some people use ratios such as PER and P/B. Some people look at charts, spotting 52 weeks highs and lows. Some look for the highest yields. The list goes on. When I first started, I felt overwhelmed and didn’t really know what to look for.

Over the years, I adopted an approach that is similar to Graham's “large companies that are out-of favour” tactic. I look at alpha cyclical companies during their down cycles and I believed that will offer some margin of safety.

I bought into 2 counters, Golden Agri and YZJ, using this approach. For shipping industry, the Baltic Dry Index (BDI) hit record bottom at 661 last year. The peak was 11,000. Even if one were to take the average, we can quite safely say the BDI was nowhere near where it would be mid-cycle. Shipping down cycle is characterized by a dearth of new shipbuilding orders, collapse of freight rates, and the bankruptcies of weaker players, and all these have happened in the past 1 year. So, I can safely conclude that we are near the trough of a down cycle. Near? Yes, because there is no way to ascertain if we have reached the bottom yet.
Then, we search for alpha companies. These are companies in the sector that have the strongest financial strength and operating efficiency. This is so that our investment does not go to the dogs and get consumed by the down cycle. I shall not go into detail about YZJ, as that itself would be a long blog but, particularly, I looked out for a low gearing level.
Both Golden Agri and YZJ have low gearing levels. More important is the amount of short term loans to be repaid. Down cycles combined with the maturity of large loans is what killed many companies. Even the biggest private shipyard in China, Rongsheng, is facing severe difficulties because of this.
Next, while profits would be affected negatively, there should not be losses, and the companies should be big enough to show resilience in earnings through previous crises. There should be Free Cash Flow (FCF) in most of the operating years too
Golden Agri’s earnings are levered heavily on Crude Palm Oil's (CPO) price, and its production levels. If we look at the last 30 years, 2013 has seen CPO price falling more than 40% from its last peak. Although inventory has been piling up, Golden Agri will not be able to increase its production at the same rate it has been able to in the past. I bought it for its vertically integrated businesses and its economies of scale. For higher production growth, one should, perhaps, look at First Resources.
This approach requires a lot of patience as the sectors are out of favour and there is very little chance that the share prices would shoot up suddenly. Also, as AK always says, cheap could get cheaper and this is especially true in such out of favor stocks. Say ship building and most people would frown. So, there might be selling pressure from time to time but if the companies are fundamentally strong, such selling pressure provides opportunities for accumulation.
I would like to acknowledge that I first got some ideas and information from Calvin Yeo of "Invest In Passive Income". A link to his blog can be found in the left side bar of AK's blog.
-------------------
AK's comment:
I was heavily invested in Golden Agriculture at one time, recognising that it was heavily levered to the price of CPO. When CPO price was rising relentlessly, Golden Agriculture was a good investment. I made a tidy sum from it. Mike's approach is valid, I am sure, but one has to be patient.

We could consider investing in Wilmar International which also has an exposure to CPO but it is less levered to CPO production which forms less than a fifth of its earnings. Wilmar has a pretty diversified earnings base. However, if we are looking for positive Free Cash Flow, then, Wilmar would fail our selection process.
As for ship builders, I would also frown when I hear the phrase. However, we can find nuggets in the sector and when we look at what Cosco and YZJ are doing, we know where to look because these yards are venturing into building for the O&G industry. This is what KepCorp and SembCorp have been doing for years. With more rigs delivered, there is a higher need for OSVs and, yes, I am invested in Marco Polo Marine which has the added advantage of a strong moat. However, if we are looking for positive Free Cash Flow, then, Marco Polo Marine would fail the selection process too.
I believe that Mike's approach is probably suitable for anyone who is more conservative since stronger companies in cyclical industries are unlikely to go bust in a down cycle. When the up cycle returns, these companies should lead the recovery.

Thanks, Mike, for offering us your perspective on stock selection. It has provided me with food for thought.

25 comments:

opal said...

Thanks for sharing. When I read this article, Wilmar and NOL came into my mind. :)

AK71 said...

Hi opal,

Ah, NOL. Definitely cyclical but it had to sell its home to raise funds. I wonder about NOL. -.-"

AhJohn said...

Nice sharing! Mike!
I vested into YZJ and Noble now. Especially, YZJ also offer nice dividend.

AhJohn said...

Btw, AK, "tea with ...", is it really you talk face to face?

AK71 said...

Hi Ah John,

Oh, the "tea" is virtual but the online conversation is just as enjoyable. ;p

sillyinvestor said...

Hi AK,

Cosco went into O&G sector earlier than YZJ but fare much worse than YZJ. I would rather YZJ concentrate on their shipping building core, but management mention they have a long term goal of having O&G contribute 20% of revenue, speak volume of the management assessment of the potential of the O& G sector. However, I glad YZJ did not repeat the mistakes o other shipyards, yZJ is aware of the steep learning curve, it's first contract is through a JV, and did not follow the other shipyards to aggressively bid for contracts by lowering margin and offering attractive payment terms. YZJ insist on 10% payment at the initial stages, but china shipyards are offering 2-3% payment terms, and inevitable get into some troubles. Singapore sembcorp and Keppel required 20% payment. Such as the pricing power of established players. Management is sanguine about its first foray into O&G, saying margin will be very low, but they are more concerned about delivering to established a good track records. This to me is prudent and wise management, one of the reasons why I bought YZJ too. If u compare it with other china shipyards, I think YZJ beat most if not all of them hand down, but If u compare them with Korea yards, the. yZJ look like Mickey Mouse.

EY said...

Hi Mike and AK,

This is a great post. :)

I adopt a similar strategy, but not exactly buying the big guns. I look at the how beaten the particular counter is from its high, its price to tangible book value, cashflow, and quick ratio. I'm currently vested in Ausgroup (not shipbuilder but similar sector) and IndoAgri. Notice IndoAgri has initiated a share buyback of 10mil shares in the last 10 trading days. I entered before the CMZ saga.

Yes, I agree that patience is quite key in this approach. For both counters, they pay dividends. Quite paltry but beats bank interest anyway. :)

I was vested in GoldenAgri, Cosco and YZJ many years back. Can't imagine if I'm still keeping Cosco, pinning hopes for its recovery. I bought at $6.50. -.-"

AK71 said...

Hi Mike,

You know YZJ like the back of your hands. :D

Indeed, quality of the management team is very important and it seems like YZJ has a very prudent team.

As long as oil prices stay relatively high, O&G is going to prosper and with it the shipyards which build rigs and OSVs. Of course, we can say the same for the OSV charterers as well. :)

AK71 said...

Hi Endrene,

Long time no hear! :D

IndoAgri has a rich parent. Probably bullet proof. ;)

I read your last paragraph a few times. You still have Cosco bought at $6.50 or have you sold? 8(

EY said...

Hi AK,

I retreated to the mountains to lick my wounds. Hit a rough patch lately and needed time out from the world. Haha.

No more Cosco. I don't like to be constantly reminded of my bad decisions. I sold them at the fire sale and managed to claw back $1.00+. Bought at $6.50 cos analysts said the TP was $9. That's how I learnt never to trust analysts.

Would like to borrow your pet phrase - this is a mistake from my 'thoughtless youth'. :P Actually, even now that I'm no longer that young, I'm still quite thoughtless many a times.

AK71 said...

Hi Endrene,

Oh dear. I hope that the time spent in meditation has done its healing. Actually, I have been thinking of doing some retreating into the mountains myself, given the recent events. Sigh. :(

Well, if analysts are to be believed, some say that we should avoid Cosco like the plague and that it is only worth 50c now. If we don't trust them anymore, we should perhaps be buying now. No?

Just a thought from a thoughtless youth had been and a sometimes thoughtless man. ;p

EY said...

Hi AK,

Giving ourselves some quiet space is good. I still haven't got back my equilibrium and my sustained sense of happiness yet. Need to give myself pep talks everyday to keep going. :)

Don't be too hard on yourself. And if you need to meditate or hibernate, just go ahead. F1 driver also needs to top up fuel, right? :D

Hmmm...no more Cosco for me. Not as if it is the best deal around. I no longer have very much faith in Chinese companies. Anyway, I don't have a lot of money to invest. So I need to be very selective.

AK71 said...

Hi Endrene,

Yes, a nice break once every so often is good for the body and the soul. :)

Look forward to all the happy things that have yet to happen and I know you have a big bundle of happiness in the form of a key! Gambatte! ;)

sillyinvestor said...

Hi Ak,
I drop you another email regarding YZJ, let me know if your spam filter is "unfriendly" again? ya!

AK71 said...

Hi Mike,

I see it! Thanks. :)

I will do the proof reading once I have some time in the evenings. Good stuff. ;)

feipeng wu said...

Thanks for sharing.
It is a good article.

Gary said...

Hi AK71

What are the criteria to have tea with you?

AK71 said...

Hi Gary,

I was thinking of learning from Warren Buffett to organise an auction. One tea session a year with a reader. All proceeds from the auction will go to the 6 charities I support regularly.

Kidding. ;p

"Tea" in these guest blogs is metaphorical. I have not seen Mike in person before. :)

Gary said...

Hi AK,

Not a bad idea to have "auction"! Hahaha! I really thought you met these bloggers! =)

AK71 said...

Hi Gary,

Really? You like the idea of an auction for my time?

Sunday afternoon tea with AK71 lasting 3 hours! Reserve price... er... how much har? LOL.

The very idea makes me laugh. Cannot, cannot. ;p

Gary said...

Hi AK

The value of the tea will be priceless!!! =))

AK71 said...

Hi Gary,

I am truly honoured (and flattered)that you think so. I will have to sit on the idea for now as I am not very comfortable with giving up my privacy.

Of course, if it is for charity, then, the idea to me becomes more appealing? :)

AK71 said...

"Soy brings in the money. It has the nutritional value of meat but it's vegetarian. And it's the cheapest protein in the world to produce by mass," explained soy expert Marc-Henry Andre.

"Up until now, the supply has increased sharply. But the demand has grown even more, which explains why the price for a tonne of soy exceeded $100 in the early 2000s and is now above $500," said Argentine economist Luciano Cohan.

China imports soy beans at the rate of 60 million tonnes for 2012-2013 and an expected 70 million for 2013-2014. It then transforms the soybeans into oil or flour.

http://www.channelnewsasia.com/news/business/international/china-demand-fuels-record/815878.html

“The current weather conditions in the U.S., which is driving soybean oil prices up, will have a positive spillover effect on palm oil prices because soybean oil is a close substitute to palm oil,” said Sim Han Qiang, an analyst at Phillip Futures Pte. in Singapore. “When soybean oil prices increase, it tends to put buying pressure on crude palm oil.”

Soybean oil’s premium over palm oil gained to $253.24 a ton today from $245.82 on Aug. 16, according to data compiled by Bloomberg. Soybean oil for delivery in December rose 1.3 percent to 43.73 cents a pound on the Chicago Board of Trade. Soybeans for November advanced 2 percent to $12.8425 a bushel. The most active contract advanced 6.5 percent last week, the steepest gain since the five days ended July 20, 2012.

http://www.bloomberg.com/news/2013-08-19/palm-oil-jumps-to-five-week-high-as-soybeans-rally-on-weather.html

AK71 said...

“We have emerged from 2013 a stronger, better company, characterized by stable and diversified earnings,” Wilmar Chief Executive Officer Kuok Khoon Hong said in the statement.

Source:
http://www.theedgesingapore.com/the-daily-edge/business/47339-wilmar-q4-profit-drops-23-on-taxes-sugar-business-.html

AK71 said...

"Oil prices will be depressed for a year or two, and it's not a good time to buy (palm oil plantations) right now," said Kuok.

Source:
http://www.theedgesingapore.com/the-daily-edge/business/49469-wilmar-says-chinas-palm-oil-imports-under-pressure-in-short-term.html

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