Select Page

Beginner’s Guide To Investing

Class 11

3 TYPES OF VALUE TO BE FOUND IN THE STOCK MARKET

After investing for more than a decade, looking at hundreds of companies and interviewing many great fund managers around Asia, I have found that typically there are just three types of value to be found in the stock market. They go by many names by different investors, we at Value Invest Asia like to call them as:

  • Asset Value
  • Current Earnings Power Value
  • Growth Value

Asset Value

Asset value is a method used to value companies based on their current asset value. It is about finding a stock that is undervalued based on its asset value. A simple way to do it is to compare the company on ratios such as Price to Book (P/B) ratio or Price to Tangible Book (P/TangB) ratio. This type of valuation might be useful for companies with liquid assets, assets that can easily be converted into cash, like a bank or insurance company. Or it can be used to measure companies that are liquidating or companies with easily measurable assets such as property companies.

This method is made famous by Benjamin Graham in his book “Security Analysis”. He termed the type of investment that is deeply undervalued as “Net-Net” company. These are companies that are so cheap that if Graham bought them and use just its Current Asset to pay off its entire liabilities, both current and non-current, he would still profit from the investment.

For example, if a company like has a total Current Asset of about $5.0 billion and total liabilities of about $3.0 billion, it means the company has a net-net equity of $2.0 billion. And if the company is only trading at a market capitalization of $1.0 billion in the market, it means in theory, you can buy the company at $1.0 billion, liquidate just its current asset and pay off all its liabilities, you will still make a profit of $1.0 billion and get all its non-current assets for free.

In theory that is. Later on we will look at some of the advantages and disadvantages of using this method of valuation.

First Step: Creating a Story

The process of valuation starts with creating your version of the story about a company. We must first understand the business of the company and form our opinion on the opportunity and risk of the company. Think of it as how are you going to explain this business to your friends when they ask you about it. We have to form a clear picture of why we are investing in this company in the first place with our story of the company. Then we will look into translating this story into our valuation models.

For this example, we can look at Singapore-listed Hongkong Land Holdings Limited (SGX:H78). And after researching on the company, this is my story of the company.

To create a story of the company, I basically try to answer this 6 segments:

  • Its business: What does it do?
  • Its addressable market: How big is its market?
  • Its strength & opportunities: What is the potential and advantages of the company?
  • Its weakness & threats: What is the risk and shortfall of the company?
  • Its reinvestment characteristic: Is this business capital intensive?
  • Risk Assessment: How would I classify the risk factor of investing into this company.

Bear in mind this is just my personal version of Hongkong Land Holdings’ story. Everyone of you might see the company differently and have a different variation of your own story. This is important to note. The idea is to have a story you are comfortable with. So when you translate this story into numbers in your valuation, you can feel confident in your work. If you are simply following someone else’s valuation or story, you can never truly feel confident in the work and you would not have the will power to hold on to the stock when a crisis arises.

My Story of Hongkong Land Holdings

Business & Addressable Market

I see Hongkong Land as a very simple business. It is in the real estate ownership and development business. It holds some of the most valuable commercial properties in Hong Kong and Singapore predominately. It also has a development business in markets like China, Singapore and even Southeast Asia. That would be its addressable market. I do not see it venturing outside of its key markets.

Strength & Opportunities

The strength of the company is that is has a very strong balance sheet. Its debt level is very low for a property company. Moreover, most of its debt are backed by Grade A properties in Hong Kong and Singapore. Lastly, due to its development business, it has the growth opportunity of growing in ASEAN and in China, where most of its property development projects are located.

Weakness & Threats

However, there are some weakness and threats in the business. For one, the company is mainly managing many of its legacy properties. This means that management might is quite conservative and might not be very motivated to grow the business aggressively. Moreover, the property market in Asia, especially in Hong Kong, Singapore and key cities in China are quite inflated. Some might even see it as a financial bubble within the property space. Therefore, there is a real risk that property price might face a sharp decline in the near future.

Reinvestment

The business of Hongkong Land Holdings is highly capital intensive. Developing and owning properties requires a large capital. Thus, the company might not be able to dividend out a large portion of its earnings every year.

Risk Assessment

With all these, I concluded that Hongkong Land is in a cyclical business that might not grow very fast. Yet, most of its value are backed by real hard assets; properties. Thus, I can deemed it as a mid-risk type of company.

Advantages & Disadvantages of Asset Valuation

Advantages Disadvantages
Easy To Use: The method can be easily applied by simply adjusting the assets of the company Value Might Not Be Realised: Value is based on the assumption that the asset can be liquidated, but it is not always the case, especially if we are not the majority shareholders
Fast To Apply: The process is fast and it only look at one aspect of the company, its assets The Need For Catalyst: Without an event to happen within the company, the value might not be unlock
Easy To Compare With Peers: We can easily find out the assets value for its peers and compare which company is the cheapest among its peers Falling Into Value Trap: Value traps are companies that appear to be cheap based on valuation methods but they will not raise in prices as there are some issue restricting the value to be unlock. Issues can be fraudulent practices or mismanagement by the managers or towering control by the main shareholders.
Easy To Compare With History: We can compare the valuation of the company with its own history to know if it is cheap now compared to its past

Current Earnings Power Value

A second method of valuing a company is using the Current Earnings Power Value. This is suitable for company with consistent earning power. These companies might be referred to as “Money machine”, that is able to generate strong and stable profits and cash flow with predictable growth. Current Earnings Power Value is mostly used for mature companies with stable growth.

Companies that might be valued using this method are Nestle (Malaysia) Bhd, Carlsberg Brewery Malaysia Bhd, Starhub Limited, China Mobile Limited. Common metrics used to value these companies can be using Dividend Yield, Price to Earnings (P/E) ratio or the Discounted Cash Flow method.

Creating a Story

For this example, we can look at Carlsberg Brewery Malaysia Bhd (KLSE:CARLSBG).

My Story Of Carlsberg Brewery Malaysia

Its Business & Addressable Market

Carlsberg Brewery Malaysia is in the business of manufacturing and distributing alcoholic beverages in Malaysia, Singapore and Brunei. It is a listed-subsidiary of Carlsberg A/S. This means it would only be distributing brands within the Carlsberg portfolio. It has a 25% investment in Lion Brewery, the largest brewery in Sri Lanka.

Strength & Opportunities

The company has a very strong relationship with its parent company, Carlsberg A/S. That would make it less dependent on the market for funding needs. It has a very strong marketing and distribution network in all its key countries. Thus, it is one of the top alcoholic brands operating within the three countries. There is still huge opportunity for the company to grow its brand portfolio. This is because, Carlsberg Malaysia is only distributing about a dozen brands while Carlsberg A/S owns more than 400 brands in its portfolio. The company can easily add more brands into its portfolio in the future.

Lastly, it has very strong pricing power in the market. Over the years, the company has demonstrated its pricing power by raising its selling price right after the governments raise the excess duties of alcoholic drinks. Yet, rarely will the company experienced long-term drop in its demand.

Weakness & Threats

Having said that, the company do have some risks. It might lack growth going forward. It is already a key player in the market it serves. Moreover, it is a listed subsidiary of Carlsberg A/S and might be restricted to expand into other oversea markets.

The company is also highly dependent on the regulations in the countries it serves and the success of Carlsberg A/S at large.

Reinvestment

The company has very low reinvestment needs and is a money machine. It generates strong free cash flow that has been consistent over the years.

Risk Assessment

Thus, I see this company as a very low-risk and stable business. Thus in my valuation, I might be willing to accept lower return for investing in this company.

Advantages & Disadvantages of Current Earnings Power Valuation

Advantages Disadvantages
Easy To Use: The method can be easily applied by simply adjusting the income statement of the company More Assumptions Needed: Because we are looking into the earning power of a company, we have to make more assumption on how well the company is managed and what margins it can achieved.
Fast To Apply: The process is fast and it only look at one aspect of the company, its earnings Miss Out On Growth Companies: Business dynamics are always changing. Therefore, even if the company is a mature stable growth company now, it might hit into a fast-growing sector and change the dynamics of the company. However, this method of valuation would not be able to take that into consideration
Easy To Compare With Peers: We can easily find out the earnings power value for its peers and compare which company is the cheapest among its peers Not Applicable For Some Type Of Companies: Companies like conglomerate or highly cyclical companies might not be easily measured using this method as the business environment is always changing.
Easy To Compare With History: We can compare the valuation of the company with its own history to know if it is cheap now compared to its past

Growth Value

Lastly, the last type of valuation method is known as Growth Value. This method is mostly used for companies that are still in a fast-growing stage or companies with very little history. Basically, for companies that their value is coming from the future growth potential of the company. These means that the company are seeing the main bulk of its profit and cash flow to be generated in the future. For a startup, a disruptor of an industry or just a company within a fast-growing industry, Growth Value is where the main value of the company is.

And interestingly, because most of the value of the companies are lying in the future, these type of companies typically are trading at very high Price To Earnings (P/E) or Price To Book (P/B) ratio. However, a more appropriate way to valuing it is with the Discounted Cash Flow method.

Creating a Story

For this example, we can look at Hartalega Holdings Berhad (KLSE:HARTA).

My Story Of Hartalega Holdings Bhd

Its Business & Addressable Market

Hartalega is in the business of manufacturing and export of latex and nitrile gloves. It export its product globally with 80% of the revenue coming from North America and Europe.

Strength & Opportunities

Hartalega is the leader in nitrile glove production. More than 80% of its production volume is focused on nitrile glove. The demand for glove is also growing fast. Over the past seven years, global demand for rubber gloves is growing at 8% a year. Glove export from Malaysia is growing much faster at 12.6% a year.

Hartalega is also well position in the market as more of the rubber glove demand is moving toward nitrile gloves. In 2016 alone, nitrile glove volume grew by 33.5%. Moreover, Hartalega has a clear growth plan till the year 2020. It is planning to add about 28.2 billion per annum in its glove capacity. That additional capacity is about 3 times its current size in 2015.

Weakness & Threats

However, I feel that Hartalega has some risks ahead. For one, it is still just selling a commodity product which it has no control over the selling price. At the moment, it is still highly dependent on the healthcare industry and also its export to the North America market.

On top of that, all its major competitors in the glove industry are expanding aggressively. This might lead to an oversupply situation in the near future, resulting in a sharp drop in its selling price.

Reinvestment

Although the company need to build more factories to increase its capacity, its historical return on assets has been quite high; around the range of 10% to 20%. Thus, its reinvestment characteristic is still considered moderate.

Risk Assessment

The company can be considered a mid-risk business for me as it produces a necessity product and it has a market leading position in the nitrile glove space.

Advantages & Disadvantages of Growth Valuation

Advantages Disadvantages
Give Us A Guide On Valuing Fast Growing Companies: It is not easy valuing fast growing companies, so this method give us a guide on how to do that systematically. Messy Assumptions Needed: There are many assumptions to be made in order for us to come up with a value of the company. Therefore, it is important to know that it is still a type of estimation to the best of our ability.
Force Us To Give Logical Assumption During Valuation: Often when we hear the story of a fast growing company, we might get carried away by the impressive story. But going through the valuation force us to give logical assumption on how fast the company should be growing and what its intrinsic value should be. 100% Inaccurate: One thing we can be certain when valuing fast growing company is that we will make mistakes in our assumptions. That is why we need to incorporate the idea of margin of safety when valuing these companies.
Not Comparable With Its Peers: The discounted cash flow for each company is different. Therefore, it is hard to compare the value of one company against the other. We would have to redo the whole exercise for each company for each valuation.

 

%

Completed

Level Up

%

Motivated

Now Available On Book Depository

Our Course is created based on some of the materials discussed within the book. Our book will take you through a more detailed study into how to apply value investing concepts in Asia.

And Amazon.com

“The book is a great contribution to the investing society. Stanley and Mun Hong have been able to put together the valuable experiences and wisdom of many Asian outstanding fund managers!”
Dr. Tan Chong Koay

Executive Chairman, Phiem Asset Management

“This is not just a book about value investing. Instead, it is a manual for value investing with an Asian twist that investors with an eye on the fastest-growing region in the world will reach for whenever they have questions that need answers.”
Dr. David Kuo

CEO, The Motley Fool Singapore

“Stanley Lim and Mun Hong have skillfully weaved three things together in this book for the Asian investor: the key principles of value investing, where to identify the investment opportunities and the mine fields to side step in Asia. With these skills, the investor can start investing in Asia.”
Mr. Wong Kok Hoi

Founder & CIO, APS Asset Management

Facebook Comments

Pin It on Pinterest

Share This

Share This

Share this post with your friends!