Hi all,
I realized more and more that there is a growing misconception of of PRIME PRINCPLES in investing, aka:
LOW PE STOCKS = UNDERVALUED,HIGH MARGIN OF SAFETY, SAFE BUY
HIGH PE STOCKS = OVERVALUED, LOW MARGIN OF SAFETY, RISKY BUY
This as a basic principle in investing is something that all fundamental and technical analysts put at the back of their mind.
HOWEVER:
Let me try to explain the BUSINESS SENSE behind the usage of PE.
PE, or price to earnings RATIO , is simply what MADAM MARKET (here I put the irrationality that is my WIFE) is willing to pay you for your business. And as you know all women, they would buy 10 things that they dont need just because it is CHEAP in comparison to normal supermaket prices, rather than buy something EXPENSIVE that they really need.
ALLOW ME TO ILLUSTRATE:
Take for example.
If you went ahead and bought a stock that had a finite life, let say for example (bursa: FIXED4) which is a fixed deposit company that would pay you 1 year of earnings and dissapear forever, how much would you pay?
Imagine after 4 quarters of earnings report using 1 dollar of revenue, you will earn exactly 4 cents. (it says so in the prospectus). How much would you be willing to hold this stock? (of course assuming you live in Germany, with its negative interest rate)
Exactly: The share price of the stock would be exactly 4 cents.
Or more importantly: PE= 1.
Does this make this a good share or bad share? NO. all it means is that Madam Market know EXACTLY how much they will get from this business during its entire lifecycle. Why should you pay more for something that has no UTILITY OR GROWTH PROSPECTS?
HOW THIS WORKS IN THE REAL LIFE
I would like to use a particular stock comparison:
LEONFB:
in 2017, it did 577,357 million on 80 million net profit, with a PE = 1.93. it has a net equity of 334 million, today we are valueing the whole company at 155 million.
Now, is low PE = good undervalued company that will perform over time?
No, definitely not.
https://www.google.com/search?q=leonfb+share+price&oq=leonfb+share+price&aqs=chrome..69i57j0j69i60l2j35i39j0.3038j0j9&sourceid=chrome&ie=UTF-8
Low PE merely means either:
1. My wife has no confidence in this company in the long term
2. My wife has calculated the terminal value and cash flow possibilities for this company for the long term, and she decided that she is willing to pay only 50 cents for this 25 cent earning company, because this is how much she knows she will get over its entire lifetime
3. My wife does not know basic algebra, and does not realize that if you force sell the entire company, you will get more than the share value in terms of assets. (however on hindsight, she does realize that as a minority shareholder you cant do anything in the company, and a stock can go years of mismanagement before declaring bankruptcy or privatization)
But how does this unconfidence come about?
Financial Year Ended 2013 2014 2015 2016 2017
Revenue 455,268 489,194 505,404 498,716 577,357
Profit After Tax 25,773 27,547 18,479 27,678 80,369
Net worth 202,532 222,344 234,606 257,641 334,199
so if you ignore the gain from the compulsory acquisition of land by government, you would realize that the business itself is barely growing its earnings and equity. And if you use your business sense, you would realize a steel trading and processing company is usually a high capex company with a lot of leverage selling products that have no pricing power and is easily obtainable everywhere.
Ergo, if the business does well, everyone will come in and do the same thing, lowering your revenues. And if the business is not doing well, it is not making money anyway, so no one will be doing it.
SO, MY WIFE DOES KNOW WHAT SHE IS DOING AND HAS CHOSEN TO PAY BOTTOM DOLLAR FOR A COMPANY THAT DOES NOT GROW AND HAS NO GROWTH TRIGGERS IN THE 5-10 YEAR ESTIMATE.
With the opposite,
a high PE stock also does not automatically mean that the stock is an overvalued bad stock.
Take for example this company, my favourite:
Financial Year Ended 2014 2015 2016 2017 2018
Revenue 2,457.19 2,706.91 2,853.23 3,012.00 3,263.14
Profit After Tax 159.93 191.40 192.08 195.92 206.24
Net worth 1,278.86 1,420.32 1,584.51 1,737.24 1,781.98
Financial Year Ended 2009 2010 2011 2012 2013
Revenue 1,397.91 1,476.40 1,777.08 1,946.67 2,146.31
Profit After Tax 89.33 106.91 124.55 131.41 131.71
Net worth 412.40 496.45 727.30 804.01 883.55
Now, compare it to this company. This is also a trading and processing company that has high capex requirements selling livestock products that have no pricing power and are available everywhere.
in 2018, it did 3.263 billion on 206 million net profit , with a PE = 53.89. it has a net equity of 1.781 billion, today we are valueing the whole company at 11.14 billion dollars.
PE= 54?
Wow isn't that horrible? Buying a company with PE that high should be a wrong move, right?
Not exactly. High PE merely means either:
1. My wife has overconfidence in this company because her market lady told her this stock is chun chun win one!
2. My wife has calculated the terminal value and cash flow possibilities for this company for the long term, and she decided that she is willing to pay up for the company growth as it has shown capability of transitions into multiple revenue streams.
3. My wife does not know basic algebra, and does not realize that if you force sell the entire company, you will get 20 cents to the dollar.
So you see, if you think of it in business terms. High PE is merely the mark of a company outperformance (or 99% of the time admittedly sadly investor greed). But assuming major shareholders are minimally educated investors (and not i3 speculators), how do we look at high PE companies? We should look in terms of growth patterns and triggers, ADJACENCY EXPANSION, ORGANIC GROWTH.
How to look at business sense of PE via GROWTH TRIGGERS:
Pre 2000 - Feedmill trader company (penny stock, low expectations of future, low PE)
2000 - paid up capital 40 million, small surimi trader, feedmill plants open up - On 15th December 2000, QL acquired the poultry layer farm assets of Syarikat Wim Hing Poultry Farm. Diversification and vertical integration of feedstuff and poultry farming (some slight confidence in their ability to grow, but its just a company like any other)
2001 - On 23rd April 2001, QL acquired 80% of the shares in Figo Marketing Sdn Bhd and Figo Foods Sdn Bhd. (higher confidence now, they are doing organic growth into food for human consumption, they have decided to stop being subcon and become maincon)
2002 - QL acquired 65% of the shares in QL Breeder Farm Sdn Bhd and QL Tawau Feedmill Sdn Bhd, further diversifying our farming activities to encompass breeder and broiler farming in Tawau (even more confidence now, they have gained the management capability to manage territorial expansion. No more jaguh kampung, reach LAYHONG LEVEL)
2003 - QL commenced operation of the second CPO mill in Tawau region. The opening of the second oil mill increased our palm fresh fruit bunch (FFB) processing capacity to 500,000MT per annum. (exploding confidence now, they started the first one in 1998, now fully diversifying into palm oil plantation + vertical integration into refining business via boilermech, reach UNITED PLANTATIONS LEVEL CONFIDENCE)
2004, QL’s marine business expanded its business beyond Peninsula Malaysia by establishing an integrated marine base in Kota Kinabalu. The Kota Kinabalu operation includes upstream fishing, as well as downstream surimi, frozen seafood and fishmeal processing. The operation diversifies our marine resources supply and added processing capacity of the group. (even more confidence now, as they have fully diversified into marine and are doing well in multi region expansion, become from maincon into developer level)
2005, QL ventured into deep sea fishing operations with 5(after 13) fleets of purse seiners in Endau, Johor. (integrated and expanding in all the right areas. The magic word no diversification into silly stuff like property development etc, staying in their core capabilities, adjacent expansion of revenue streams. Excellent, ECSTATIC CONFIDENCE)
August 2006, QL made its debut foreign investment in Eastern Kalimantan, Indonesia. A joint venture of 74.5% (QL): 25.5% (Indonesian partner) was established for the purpose of oil palm plantation project. The project involved developing two parcels of plantation land into oil palm plantations in East Kalimantan, Indonesia, measuring approximately 20,000 hectares. This investment in Indonesia represents QL first regional replication of our business activities. (NOTE THE WORD SUCCESSFUL REPLICATION OF BUSINESS ACTIVITIES OUTSIDE MALAYSIA.
GROWTH TRIGGERMay 2008, QL incorporated a subsidiary, QL Vietnam AgroResources Liability Limited Company. This subsidiary is to carry out poultry layer activities in Tay Ninh province, near Ho Chi Minh. In November 2008, QL incorporated a subsidiary, PT QL Hasil Laut, in Indonesia. This subsidiary is to carry out surimi and fishmeal manufacturing. Both the above investments are our efforts to further replicate our existing business model and activities in the region. (FULL EXPANSION BEYOND MALAYSIA INTO ASEAN REGION. WE HAVE GONE BEYOND BORDERS. CAPSLOCK TIME!!!! OVERCONFIDENCE)
2009 - WE HAVE GONE MAXIMUM OVERCONFIDENCE OVERLOAD. THEY HAVE SHOWN THE ABILITY TO OPERATE WELL IN A BUSINESS WITH LOW MARGINS AND HIGH CAPEX. THEN TRANSITION INTO MARINE, POULTRY AND AGRICULTURE. THEN VERTICAL INTEGRATION WITH BOILERMECH, FOOD PROCESSING AND PRODUCTION. THEN GLOBALISE WITH STABLE EXPANSION PLANS BEYOND MALAYSIA BORDERS!!!! LETS NOT BUY THAT HOUSE! LETS PUT MY FUTURE IN QL STOCK, 200K WORTH! LETS GO! LETS MARGIN LOAN THIS! 500K!
And the rest is that.
My summary is simple.
Dont look at PE as another indicator to buy or sell a stock. Use PE as a guide to tell you what the business confidence(or business performance) is in the stock. If PE is termporarily low, then there might be a mispricing. (which is very rare these days in the age of the internet) If the PE is consistently low, it may be a sign that the business is not growing, not earning, or not rewarding shareholders.
Same as the inverse, a high PE can mean overconfidence (which is very highly possible, especially in the days of the internet), or it can be a indicator of business performance. IF a business can guarantee safety, stability, high vertical integration and moat-like qualities, it deserves a PREMIUM.
I hope you learned something,
Philip
- free Philip quote of the day. If you only have the free time to be a part time investor in a company, then you are a full time gambler.
https://klse.i3investor.com/blogs/phillipinvesting/190569.jsp
