My
dad has an old friend called Ah Cheong. Ah Cheong lives most part of
his life as a mechanic, by operating a small workshop with two
apprentices, until his age caught up with him and he decided to retire.
The day he closed his workshop, my dad dramatically said there will
never be a better mechanic in this town. After his retirement, Ah Cheong
invests in cars to pass time. Unlike some people who buy cars to rent
out, or buy second-hand cars with hope to sell them at a higher price,
Ah Cheong has a very different car investment strategy. He buys old cars
which are virtually junks, with no condition to run anymore, or even if
they do, they are going to incur consistent maintenance cost that is
higher than buying a new one. Ah Cheong can usually buy these junk cars
at very low prices, some of them were even willing give out as free just
to get rid of the cars. After that, he would dismantle the car and sell
their parts like the rims, battery, audio system, engine cooling
system, tyres, scrap metal, almost every parts of the car, and make a
profit out of it, by leveraging the connection and experience he
acquired over his career.
I
always thought of the story of Ah Cheong whenever people ask me how
much return can they get from stock investment. Or when they asked me to
compare the potential return between stock investment and property
investment, or any kind of investment. There's no answer to it, I
believe. There are so many types of investment you can make nowadays.
And the potential return, is based on how much you love, how much you
know and how much you are willing to learn about the subject of your
investment. I doubt if Ah Cheong is going to do good in stock
investment. Similarly, despite all the lucrative return my rich uncle
brag about his investment in paintings and artwork, I don't see myself
involved in some artwork trading that I have no interest at all.
The
last thing we want is Stockify being seen as a tips giving website to
the readers. We would like to think Stockify as a website for readers
with equal passion in stock investment (just like how passionate Ah
Cheong is about the cars).
Benjamin
Graham, the father of value investing, would not be a stranger to you
if you are serious about value investing. His techniques helped found
the school of value investing, the idea of investing in securities
trading below their determined intrinsic value. His disciples include
Irving Kahn, Walter Schloss, and most notably Warren Buffet. Warren
Buffet once said: "To me, Ben Graham was far more than an author or a teacher. More than any other man except my father, he influenced my life.", at the preface of the Fourth Edition of Benjamin Graham famous book, The Intelligent Investor, which is generally acknowledged as the bible of stock market.
Although
some would say that Benjamin Graham is the extremist in value
investing, it is undeniable his investment philosophy about the
fallibility of future predicting, irrationality of the market,
investing with sufficient margin of safety, investing from business
perspective, are still widely applicable and serve as the roots of value
investing. One of the techniques developed by Graham is called "net-net
investing", which is to invest the stock at a price below net-net-working capital (NNWC) per share.
NNWC = Cash + (Receivables x 0.75) + (Inventory x 0.5) - Total Liabilities
To
translate to English, NNWC theoretically measures the money you would
still get back as a shareholder if the company went through liquidation.
It conservatively assumes zero value on non-current assets, 75%
successful collection on receivables and 50% discount on clearing its
inventory, and deduct all the liabilities of the company. In other
words, if you are buying a stock at a price below its NNWC, you would
still get back more than what you have invested even the company
liquidated its business.
We
did find a company listed in Bursa that is trading below its NNWC
using 2QFY17 figure, which is FACB Industries Incoporated Berhad FACBIND
(2984), and we will use it as the case study in this post.
NNWC of FACBIND
= Cash RM 153,864,000 (excluding RM 1,570,000 pledged to bank) + Receivables RM 17,466,000 x 0.75 + Inventory 12,799,000 x 0.5 - Total Liabilities RM 9,730,000
= Cash RM 153,864,000 (excluding RM 1,570,000 pledged to bank) + Receivables RM 17,466,000 x 0.75 + Inventory 12,799,000 x 0.5 - Total Liabilities RM 9,730,000
= RM 153,903,000
divided by total no. of shares outstanding 83,883,000 units
NNWC per share = RM 1.83
As at 28 April 2017, FACBIND is trading at RM 1.25, more than 30% discount to its NNWC.
One
would argue that asset based valuation techniques (NNWC is one of them)
no longer works in today's world as the businesses are turning toward
asset-less. Just look at the largest companies by market capitalization
today, Apple, Alphabet (Google), Microsoft, Amazon.com and Facebook,
these companies hold very little assets in relative to their revenue and
earnings. Even manufacturers, with technology advancement machines are
getting more efficient, therefore less machines are being used,
resulting in less factory space being occupied. This argument is true to
certain extent, but not applicable to Benjamin Graham net-net strategy
as it conservatively takes only 3 assets into consideration, that is
Cash, 75% of receivables and 50% of invemtory, giving zero value to
property, plant and equipment.
Just
before you jump into FACBIND first thing in the morning, there are
actually considerations to be made beyond looking at the NNWC number.
1) Something must be wrong...
Of
course something must be wrong! There's no business owner with a sound
mind would sell his company at a price below NNWC! The first task for
investors is to identify the reason for the stock to trade below its
NNWC. It could be drastic changes like losing the main client, the
biggest trade receivable went default, the main product of the company
is no longer needed by the market, being accused of accounting fraud and
so on. After identifying the reasons, ask yourself if you are still
interested in the company even if it is trading at a dirt cheap price
below its NNWC.
In
the case of FACBIND, we believe it is the serious lack of transparency
of the company making it unwanted. We understand that the company is
operating in three divisions, i.e. the bedding operation, the stainless
steel operation and association in power plant operation. From the
latest financial report, we know that its bedding operation is profit
making, while the stainless steel operation and association in power
plant operation are loss-making at the moment. And that's all we
know! The management don't even bother to disclose the breakdown of the
revenue, profit (loss) in each division, making it impossible for
investors to conduct further research, thus shy away from the company.
FACBIND
is also a loss making company in disguise. The company looks profitable
on the book, but when we took out the other income from the Income
Statement, the business is hardly profit generating, as indicated in
Illustration 1 & 2. Details of the other income is not again not
being disclosed, but we believe it is mainly derived from interest on
Fixed Deposit.
Illustration 1: Profitability of FACBIND over the years
Illustration 2: Normalised profit margin of FACBIND over the years
2) How long can the business sustain?
Now
you know the problem with the company, so the next question you should
ask is: "How long the company is going to last given current situation?"
We
mentioned that NNWC is the money you would still get back as a
shareholder when the company went through liquidation. However,
liquidation is not likely to happen right after you bought the stock. In
fact, liquidations are rare in the market. Therefore, most of the time
you actually are waiting for the market to give a fair valuation to the
stock. The point is, you have got to wait anyway. Net-net
investing selects it picks based on the value of the cash, trade
receivables and inventories of the company, so investors should make
sure that these assets are not shrinking away while they are waiting.
The
most effective way to this is to look into the Free Cash Flow (FCF)
generating capoability of the company. FCF is being used because it
measures the company's capability to generate cash from its operation
and deduct any necessary expenditure to maintain the business. If the
company is still generating FCF, there's nothing much to worry about. If
the FCF of the company is negative, calculate how long does it take for
all the cash to be burned away. In the case of FACBIND, it is still
generating positive FCF in recent two financial years, and only there is
only 1 negative FCF out of 5 financial years under coverage.
Besides
that, it is ideal to find a net-net stock without any borrowings.
External factors like the sudden spike of interest rate or strengthening
in foreign loan currency could crush the company assets. FACBIND
fulfill this criteria as well.
3) Accounting Fraud
What if everything you knew was a lie?
Net-net
investing is highly dependent on figures on the balance sheet. What if
the company falsified their financial statements in the first place?
Then it would have defeated the very reason you look into this stock.
There are many ways to assess the authenticity of a financial statement.
FACBIND's lack of transparency in its financial statements made us have
some reservations about its authenticity.
4) The right mentality
Even
if the net-net stock you found have fulfilled the all the criteria
above, do you have what it takes to invest in the company? As the cliche
goes: "It is always simple, but not easy." If
there is an award for most unromantic stock picking technique, then
net-net investing is definitely a strong contender. You are basically
buying garbage, there is no pride in it, and there is no interesting
story to tell about. Your stock will not appear on the news as the
brokers latest buy call. Worse, they could hit the headlines for the
wrong reasons, making you to question your decisions. The technique
itself is very straightforward, but not as easy as it seems.
Conclusion:
One
man's trash is another man's treasure. Junk car is trash to
most people, but it is treasure to Ah Cheong. Isn't it the same with
net-net investing?
Ah
Cheong likes the idea of junk car investing because he doesn't have to
put much time to look into every specification of the car. Just like
net-net investing, we don't have to spend too much time to look into the
business prospect, it is relatively straightforward.
Ah
Cheong never expects the junk car he bought going to be in running
condition, but he is sure that the car is trading at scrap value so
there's no much room for depreciation. Neither should you expect the
operations of a company is doing fine if it is trading below its NNWC,
but you know that there is sufficient margin of safety at that price.
The
most difficult part perhaps, it is not a romantic idea to invest in
junk cars. Nobody is going to be impressed when they see Ah Cheong's
backyard that is full of junk cars, especially at the same time my rich
uncle is constantly bragging about his art gallery. Similarly, net-net
investing strategy takes time, whether waiting for the company to
actually go through liquidation, or waiting for the market to give the
value it deserves. While you are waiting, your friends' bragging about
the kind of performance their growth stocks are making, that is
definitely going to make your wait felt longer, and more suffering.
Will you buy a net-net stock?
Note: we are not suggesting FACBIND as a stock pick, it is merely used as the case study in this post.
https://www.stockifyblog.com/single-post/net-net-stock
