Tea with Mike: Approach to stock selection

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.

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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.