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Sunday, 5 February 2017

How to make Good Investments

As investors, we are always seeking returns for our investments. In the broad definition, a good investment is an investment one can achieve returns above or at least equal to his expected returns. From a corporate's perspective, it is rather straightforward to define what is a good investment as the returns from the investments must be able to cross the hurdle rate which could be the Weighted Average Cost of Capital (In simple terms, this is cost of funds to gather cash for the investment or you can view it as the risks of the new investment) of the prospective investment before the company will decide to go ahead with the investment.

What about from a retail investor's point of view? How do we decide what is a good investment?  
Do we also apply the methodology used by corporate? Yes, this is one approach so we have analysts who will attempt to forecast the companies' future cash flows and apply Discounted Cash Flow Valuation (DCF) to calculate the intrinsic share price. If the computed intrinsic share price is higher than the current share price, it will be termed as a "Buy". To give all due respect to all the analysts who work so hard to forecast the future cash flows of the companies BUT there is no one who can predict accurately what lies in the future, not even the insiders of the company. Of course there are companies that have very stable earnings in the past so the trend may most likely continue in the near future. Therefore, the future cash flows of such companies may be projected much easier than some others. Having said that, DCF is only effective when there is a longer stream of cash flows (i.e. more than 5) so the projection of cash flows beyond 3 years will be subjected to much higher inaccuracy level even for companies with past stabilized cash flows. 
My point here is as retail investors, we should forget about trying too hard to forecast the future performance of the companies, especially when we are not experts in the industry or sector because they will most likely be off just like how analysts try to predict the results of Brexit and US presidential elections. However, it may be a good thing to have an estimated valuation of the company if it is assumed that the current business operations will continue forever.

So how do we as retail investors make good investments then? 

Personally, I view that one of the focal points is to make investments when there is HIGH MARGINS OF SAFETY between the intrinsic value and the current market value. This term was widely used by Benjamin Graham and his follower, Warren Buffet. High margin of safety does not guarantee returns but at least it greatly reduces the impact from forecasting errors. Since we may not be able to forecast the intrinsic value, we should always use book value as a cross check. If we can invest in a company below its intrinsic value and book value, then it should turn out as a rather good investment. 
For example, one can buy into a fundamentally strong company when its share price is severely beaten down due to specific news which does not have a strong impact on its business such as broad market selldown due to Brexit. Buying below historical average Price to Book or Price to Earnings ratio is also an approach of investing with high safety of margins. 

The other focal point is to enter into investments with HIGH INVESTMENT MOATS. Companies with high investment moats are able to defend their market share because their competitive edges are too strong for their competitors to overcome. Such companies have very good corporate strategies to protect their investment moats. I have to admit that I am still learning to identify such companies because it is not easy to look at business models and identify the economic moats that are accompanied in them. One of such examples is Google being the market leader in search engines and online advertising avenues. The strong competitive edge it holds will require a long time for its peers to catch up but there is no everlasting investment moats unless capitalism is destroyed. An example is Nokia whose investment moats slowly got eroded without them knowing and when they realised it, everyone is already using smart phones. A piece of advice for those who may not be able to identify investment moats easily, focus more on high margins of safety first because this will allow one to buy cheap companies. 

Next question is probably on the time frame for these investments to reap the returns we are seeking for before they are considered as good investments? 
We may be able to buy companies at a high margin of safety and with high investment moats but will the value be uncovered within the time frame we expected? For some of these investments, we may need to wait for years before the values can be realised. Hence, investors will have to be patient enough before the value can be uncovered by some catalysts along the way and this will depend on the timing of investments. 
If you have bought Sabana Reit like the Financial Blogger, 3Fs, you are sitting on very good returns on your investments because the catalysts may come very soon such as in the case of Sabana Reit when the REIT manager announced that they are looking into strategic review together with the Sponsor, Vibrant Group. Not saying Sabana Reit is a good company but it is definitely a good investment for some like 3Fs because of the high margin of safety and good timing (but not high investment moats). Personally, I also contemplated on investing in Sabana Reit because my initial thoughts are that it may be beaten to a share price which does not justify its Net Asset Value (NAV). Afterall, it is a REIT with physical industrial properties in Singapore that should be priced at market valuations close to the NAV. But at that time, I do not think the catalyst will come anytime soon and the actions of the REIT manager are just not justifiable for me to execute my sword of value. 
For some other catalysts, it may take a longer time. One such example is probably Chuan Hup Holdings (I have a recent post on them - My First Rescue). If you are an investor who have invested in Chuan Hup much earlier like T.U.B Investing, the waiting for the catalyst may be longer even though I believe the value will be uncovered soon. Note: I am also vested in Chuan Hup recently after reading about the potential Reverse Takeover Transaction. For more details, refer to the announcements here.
Of course, the best case scenario will be perfect timing of the investments with the catalysts to unlock the value of the companies. This may be more of luck than skills as no one can consistently catch the lowest points. However, one may be able to turn to Technical Analysis to time the entries and exits of investments. I may be writing a post on this in the future so stay tuned!

As value investors, we should always be looking out for companies with high margins of safety and high investment moats. At the same time, we also need to pay attention to the timing of our investments so to try minimize the waiting game for value to be unlocked. As long as one is patient enough and the investment analysis is sound, the value of undervalued companies will be unlocked ultimately.

For now, let's continue on our Value Investing Knighthood to search for undervalued companies and sharpen our swords for the next execution.

The V.I.K

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