Monday 12 October 2015

The Question of Dividends as Passive Income

Recently, a friend directed me to Giraffe Value’s blog post titled “Investing For Dividend Income(Passive) is a Fairytale!!!”  The angle about dividends (that they cannot be considered passive income) brought forward by GV is refreshing indeed but I believe GV has missed out some salient points and thus decided to offer an alternative perspective in this topic by commenting in his blog. With GV's knowledge, I herewith copy my comments (with very minor edits to make things more easily understood) below. It may be helpful if you first read GV's article to understand his take on dividends.

dividend as passive income
With the CD & XD effect, are Dividends paid out still considered Passive Income to the investor?
Readers of this blog would have realized my reply are drawn out of and adheres closely to the "Business Perspective" section in my Stocks Investment Philosophy in which my investment framework is based on.

Also, as shown in my reply, I did agree with some points underscored by GV. My intention here is to bring about healthy discussions in the hope of getting more clarity in this subject matter through insights and thoughts provided by readers and investors.

Hi GV,

Good effort on your post. However, I wish to highlight an alternative viewpoint that I personally feel provides a more inclusive and comprehensive take about dividends. I believe the point of contention here is whether dividends paid out is considered ‘passive income.’ 

First and foremost, I assume that your 2 questions are valid in identifying whether passive income is involved. I would also add-on a 3rd point to make the argument more robust:

1.           Are you richer after getting that dividend?
2.           Would your capital not get compromised after you receive the dividend?
3.           Is the money received passive (as opposed to the word ‘active’).

As a fundamental investor (I think you are one as well), perhaps it is more insightful to look at holding the stock as being part-owners of the business. To avoid complication, let’s just assume that we have 100% ownership of a business. This view point can be easily extended to one who have partial ownership of the business through buying its shares in the market.

As 100% owners of a profitable business, we employ officers to add value to goods and services produced so as to generate income for us. Every dollar earned from the business wholly belongs to the owners. In the general sense, if earnings are $10M and beginning of year assets is $100M, the company is now worth $110M. Going back to the 3 questions above, It is clear that with full ownership of the business and by way of earnings generated, the owners are now 1) $10M richer and obviously 2) their capital is not compromised. Also, as the officers are the ones doing the hard work, we can conclude that 3) it is ‘passive’ in nature. With this, we can say the earnings are passive income to the owners.

The owners have the option to either keep the money in the business as retained earnings or issue the earnings out as dividends. If say, $5M of the earnings are released as dividends, the company is now worth $105M. But because the owners own the business, their net worth is still $110M ($5M dividends received plus $105M worth of business assets wholly owned by owners) which necessarily means that in totality, their net worth still increased by $10M. Is this $10M still considered passive? I argue so based on the 3 questions asked above. To the owners, these dividends are in actual fact just a proxy to get hold of the passive earnings of the company.

Your take regarding the HDB is almost exactly the same as the above scenario where it fulfils the 3 questions asked. Because in the stock market, we are partial owners of the company, we tend to consider only the dividends ($5M) and neglected the fact that the remaining $5M of the earnings fully belonged to all shareholders as well (I believe your argument missed this point too). So this $10M of earnings is akin to the rental income we get from a fully owned HDB property.

Now let’s think from the standpoint of the stock investor. Here, I would agree with you that an investor should consider both capital appreciation and dividend return but I just want to highlight that dividends in the investor's perspective are still passive income. Investor A purchase a stock a $1 and price appreciates to $2. The company subsequently declares a $0.50 dividends and share price proceeds to drop to $1.50 due to the XD effect. Investor B purchases a stock at $1 and price appreciates to $2 with no dividends declared. Both investors had a net gain of $1 from their investments. Considering both realized and unrealized gain, it is clear that they are all passive income to both investors. Having no net gain between Investor A and B does not mean there are no passive income involved.

I also agree that your left pocket right pocket - zero sum game theory makes perfect sense (but this does not mean dividends are not passive income).  Because dividends are usually paid in liquid cash out of the company, it makes sense that stock price should drop by the amount of dividends released. If not, we will find that the net worth of the investor (which includes both dividends received as well as ownership of the business) increase inexplicably. However, this effect is just a logical stock market event to ensure that - assuming other things remaining constant - the total amount of what owners received and what the business have are the same before and after the event.

To conclude, CD-XD phenomenon is just an Event which fails to explain that dividends received are not passive income but it does not necessarily mean that dividends are not passive income. Viewed in the proper way, the owner’s earnings are passive income and since dividends usually comes from owner’s earnings, they are part of the passive income in every sense of the word.

I got to your post because a friend referred it to me. Your post must have generated strong interest as I understand that there are some follow-ups in other financial blogs which mostly agree with your point that dividends are not passive income. However, I feel that if we viewed this issue as a whole, the logical (as well as intuitive) explanation contradicts the point that dividends cannot be considered passive income. We've communicated some time back and I know you are, like me, a keen learner of stock investments. Hope to hear more about investments from you.


PS: I appreciate that readers share their views about this in the comments section below. Also, GV gave an interesting reply to this comment. Readers can refer to his blog article for that and decide for themselves which view point is more valid and logical.

Related Articles:
Our Stocks Investment Philosophy

Friday 13 February 2015

Avi-Tech Electronics Update - 30% Unrealized Gain in 2-3 Months & Half-year Earnings Report

In my analysis on Avi Tech Electronics (See Avi-Tech Electronics - Is Quick Profit Possible?), I highlighted the reasons both quantitatively and qualitatively, why I feel the company is undervalued and that the various ongoing corporate actions may serve as a catalyst to drive up the price towards its true value. Since my initial post about it on 30 December, the price has risen from S$0.074 to S$0.091 - a reasonable gain of >22% in about one and a half months. My own average price of S$0.699 would mean a 30% gain since around 2-3 months back at November. With the release of the half-yearly results yesterday, this post is just an update about how the story unfolds so far and my intended actions.
Avi Tech logo

Much Improved Continuing Operations - Industry or Management Actions?
Avi Tech Electronics Half year 2015 Financial Summary
Table 1: Avi Tech Electronics 1H15 Financial Summary (Continuing Operations)

As seen clearly from the Table 1 above, revenue, gross profit and net income show marked improvements. Similar growth may be observed in its operating cash flows (you can find out more from the company's latest earnings release).

Avi-Tech Results Including Disposal Group
Table 2: Avi-Tech Results Including & Excluding Disposal Group
I've extracted Table 2 from my previous post on Avi Tech. Here, you'll notice that the company has been loss making for many years. Also, despite cleaning up the effects of the subsidaries (they are contributing the bulk of losses for the past few years) that are in the midst of being discontinued, the core operations still show slight negative results from 2012 to 2014. Since 1Q2015, it is clear that not only did the disposal of subsidiaries help stem further losses, the improvements in core business have contributed to profitability as well. All in all, the results in 1H2015 represents a significant turnaround transition from loss-making to profitability.

Avi Tech Quarterly and Half Yearly Results
Table 3: Avi Tech Quarter-Quarter & Half Year Results (Continuing Operations)
I believe it is important to pinpoint whether the improvements in core operations are the result of improvement in trends of the industry or due to specific actions undertaken by the management. From the announcement, the management mentioned that the semi-conductor industry as a whole appears to be in an uptrend recovery and they 'remain optimistic of continued improving performance if this uptrend continues'. With improved results seen across all business segments, it is pretty clear that the industry recovery did play a large part in the increase in revenue for the past few quarters.

However, I argue that the management played a significant role in retaining these revenues especially since the company's inclusion into the SGX watchlist in 4Q14. The gross profit margin has grown from 11.3% in 4Q14 to 22.6% in 2Q15 and this is, to quote the management, 'partly the result of  effectiveness of the ongoing cost control measures and the enhancement in productivity across all business segments'. This is made clearer if we observe the drop of COGS as a percentage of revenue from 88.7% in 4Q14 to 77.4% in 2Q15. Another factor that plays a part is the significant decline of its operating expenses as a percentage of revenue from 18.9% to 9.9%. Although we do not have much information about the specifics of operating expenses, in the typical case such expenses should not provide future economic benefits to the company and thus such cost-cutting measures usually will not have serious undesirable consequences.

To sum it all up, an investor of the company should be heartened to see that the better set of results are not solely due to general improvements in the semi-conductor industry but also due to active steps taken by the management to ensure that more money flows into the bottom line.

Bonus: Cash from Discontinued Operations

I just want to highlight the fact that the discontinued operations did contribute a decent amount to the bottom line in the past 2 quarters. Although non-recurring in nature, its always good to know that its disposal will continue to throw in some amounts of cash for the company. The net asset value of this group under disposal currently stands at about $966,000.

Interim Dividends - 1st Time Since 2011

Another positive note is the resumption of dividend payments after a hiatus of more than 3 years. Coupled with the purchase of shares by directors in the past 6 months, the interim dividends declared is a clear show of confidence from management that they believe that the company has indeed turned around. The interim dividends of $0.3 cents per share represents about 3.3% dividend yield at current market prices (4.3% based on my own purchase price).


In my previous article about Avi-Tech, I estimated that the liquidation value to be about S$0.094 per share. Using the same method alluded in that post, the new liquidation value should be S$0.099. I continue to believe that this is the minimum valuation that should be afforded to the company, especially considering that the continued improvement of business operations should provide further support to its intrinsic worth. This new valuation excludes the proceeds that Avi-Tech could have received in the future from the disposal of its subsidiaries.

Avi Tech Electronics Pro Formal Financial Results
Table 4: Avi Tech Electronics Pro-Forma Financial Results
Another reasonable way of checking the valuation would be the use of pro-forma statements as shown above. The main assumption here is that management is able to continue to keep Cost of Sales and Operating Expenses at 79.9% and 10.7% of revenue, as per 1H15 results. Finance costs and Operating income have been pretty stable over the years and should not venture too far away from $0.100M and $1M respectively.

From Scenario 1, if we were to assume that revenue reverts back to its worst level seen so far in 2014 (for eg, if semi-conductor industry as a whole declines and affect sales badly), the implied P/E ratio at current price of S$0.091 is 12.7x. Do note that 2014 net earnings is negative. This difference is mainly due to management's cost cutting and productivity measures that I had highlighted above - which further shows the importance of such management actions. If we were to annualize the 1H15 results such that the revenue will at least maintain current levels (as in Scenario 2), the implied P/E becomes 11.0x. These valuations ain't that demanding at all. Of course, the P/E based on my purchase price would have been much lower at 9.8x and 8.4x respectively. (I did not include Scenario 3, which is for those who feel the improvement in the industry as a whole will contribute further to sales growth. If this does happen, valuations will obviously be more attractive.)


It seems that Avi-Tech Electronics has finally turned around. Although we can't be sure if these very much improved results can be sustained, we can take comfort that:
  1. The discontinued subsidiaries will not contribute any more losses to the company.
  2. Share purchase from directors in the past months and the resumption of dividends after >3 years indicate management's confidence about the prospects of the company.
  3. Management seems to be actively taking targeted measures to ensure profitability since the company was placed in the SGX Watchlist.
  4. The current market price of the company is not too excessive, both on a liquidation and earnings basis.
Having said all these and with the new estimated minimum liquidation value of $0.099 as a guide, I'll probably continue to hold on to my shareholdings until price exceeds above this or if there's any serious deterioration of fundamentals in the company that warrants my attention. Did any of you bought into Avi-Tech? Let me know your opinions!

Related Articles:
Avi Tech Electronics (CT1.SI) - Is Quick Profit Possible?
My SG Porfolio (Top Realized Gains & Losses) and Some Recent Picks

Long Avi-Tech Electronics (CT1.SI)

Sunday 1 February 2015

Q&A: Insights Gained from Interesting Comments

I mentioned previously in the post on Our Stock Investment Philosophy that one of the reasons for writing in this blog is to subject our investment thoughts to scrutiny and feedback so as to gain new insights in our investment journey. In the past 2 months, there are multiple comments from fellow bloggers and readers about my writings that I feel adds so much value to this blog. I couldn't ask for more. I'll like to take this opportunity to thank readers for their insightful comments and also republish some of these for the benefit of those who had have missed these comments despite reading the article.

I've tried my best to be selective and also to summarize these questions and answers so that readers can get the gist of it. Also, to save time, I've organized in such a way that you can go to the relevant heading and/or question that interests you. Of course, there are more comments which are very insightful and definitely worth a look if you have time. If you want more details, you can click on the headings to go to the relevant article (the comments section is below these articles, scroll down all the way if you want to read only those).

Sembcorp Industries - Is It Worth the Buy Now?

The one thing analysts and all investors (and myself) have been saying is the low PER their utilities segment is currently valued in. We think it's cheap if we compare it against fellow peers. But the question is, it has been for many years they are trading under PER of 10x, so I'm not quite sure what would propel the shares to be trading at 15x. We may be too optimistic in that sense. We may be wrong of course but the market has proven us wrong again and again. Will we see a day where it is trading at PER of 15x? Maybe yes one day, and we can only hope. 

Reply: I suspect that many investors or potential ones are still deeply fixated about Sembcorp’s Marine business and has not been aware of the success and growth of the utilities business, thereby undervaluing it. Like you, I’m also not sure what would propel the shares of the Utilities segment to 15x. But assuming we are not comparing with its peer businesses or the market's valuation, and only basing strictly on a discounted cash flow perspective, I think this valuation is fair considering the economic characteristics of Utilities segment (leading position, stability and predictability of cash flows etc). Basically on a zero-growth basis we are putting a discount rate of 6.7% for a respectable business.

Also, my hunch is that my valuation for the Marine segment is probably a tad too low (Earnings power of S285M vs TTM earnings of S$345M plus PER of 12-13X) and I have considered the Urban Development business to be worth zero which is definitely not true.

Lastly, some final considerations which I did not include in the post is that – the Marine segment is probably the one providing the cash for Utilities expansion traditionally. If Marine is unable to do well under current circumstances, the Utilities might be affected. Sembcorp claims that the small Urban Development business may be a springboard for further involvement in opportunities for Utilities side but so far I haven’t really seen any synergies in this aspect (anyone, please correct me if I’m wrong). I guess these business relations wasn’t completely factored into my analysis. The valuation might be higher or lower because of these but I must really thank the margin of safety for providing some comfort here.

As an investor of SCI too, I feel pretty confident. Yet, looking at the price curve, I noted that in Oct 2011, there is a dip of prices below 3.5? And that was already way beyond post crisis low period below 2.5. I had not followed SCI then and was curious why did that happen? Just pondering will a repeat happen?

Reply: Great questions posed there regarding the price chart. I think your guess is as good as mine whether a repeat of price below S$3.50 or even S$2.50 will happen. Personally, I feel there’s always a chance something like that will happen again though.

However, looking at this situation on a value standpoint may be a source of vindication. The ~S$3.40 price occurred in 2011Q4. In terms of available information then and for simplicity, we can use 2010’s financial data for reference. With earnings of S$793M (you may want to refer to the table in my post), the PER turns out to be about 7.7x which is also very attractive. Perhaps that is why over such a short period of time 3-6 months, the stock price recovered.

Alternatively, if you follow my post and using the same technique, (Here, I assume that my view of the fundamentals/stability for both Marine & Utilities is the same at that point in time as it is now (this is quite likely) & I also used latest results for Utilities but 7-years average for Marine instead of 10 years), the valuation becomes S$6650M or about $3.70/share. I ignored the other segments in both cases. It turns out that this is decidedly less attractive at that point of time compared to now on a price to value basis (Value VS Price – 2011 is S$3.70 VS S$3.40 & 2014 is S$5.15 VS S$4.15). Thus we can say that even though the price is lower at ~$3.40 in 2011, it is not necessarily more attractive when it is priced at S$4.15 in 2014. Of course there may be bias (hindsight) etc but I’ve tried to minimize them using the same method when looking at the company for both periods.

I guess the point here is that due to business developments over the years, we have better clarity in forming a rough intrinsic value estimate of the business itself which in 2014, we estimate it to be close to S$5.15 wherein we ‘wrongly’ estimate it to be at S$3.70 based on the available data in 2011. Without any doubts, we may yet again be proved wrong as the future unfolds. That's why we can't depend only on this counter in our entire portfolio.

Not satisfied with the dividend yield.

Reply: The dividend yield for Sembcorp Industries is not the best among many of the blue chip stocks around. However, I suggest that dividend yield is part of the overall analysis. 

If after analysis, we like a stock like Sembcorp but we feel the yield is too low, I think there's 2 ways to handle this: 

1. If you feel that dividends will remain constant, wait for the price to drop further to get a higher dividend yield; or

2. Ensure the current price is low enough such that there's good upside for capital appreciation. Buy at this low enough price and hope that based on the fundamentals & potential growth of the company, the earnings will increase in the long-term and maybe future dividends will increase as a result.

For me, since the current dividend yield is already good enough for me and the company has been paying dividends yearly for >10 years now, I opt for the latter point 2 which is obviously the less wiser way.

Avi-Tech Electronics - Is Quick Profit Possible?

Seems this company has trouble finding ways to make money? It's longer term prospect doesn't sound exciting. Be careful of considering liquidation value based on its current cash. Check how much it burns as well. Can disappear quickly due to operating expenses if it isn't generating profitable sales. That margin of safety may not exist.

Reply: Thanks so much for visiting my blog. I think you’ve raised a valid point here. The longer term prospect doesn’t sound exciting at all. However, I believe the beaten-down price coupled with the various corporate actions that act as some sort of catalyst have made the stock a potentially attractive investment.

With regards to liquidation value, I’ve used it as one of the indicators of the company’s value. Like I mentioned in this post, between 2011-2013, the bulk of negative earnings are attributed to the subsidiaries (they contributed –S$12.8M while core ops contributed +S$1.7M). These loss-making subsidiaries are the exact same ones that management will discontinue and this will help stem much of the losses. Core operations endured comparatively minor losses which was worst at -S$1.61M in 2013 (VS subsidiaries –S$7.6M in 2012). 1Q2015 shows core business operating profitably signalling a potential turnaround. 

With these, I believe the company is unlikely to burn as much cash as the past 3-4 years and correspondingly, the liquidation value can be used as a reasonable guide to its valuation at this point in time. Of course, the future is unpredictable and management can still burn cash in the future, especially through similar unsuccessful acquisitions. What I can say is that I did not place any positive prospects of the future in my valuation while the negative prospects are still guarded by some indication of margin of safety.

All in all, if I can find a few companies in this investment situation and at this price level for my even-type portfolio, I think the probability of profiting should be high overall. If you read my previous post on 
My SG Portfolio 2014 and Some recent picks,you will notice some companies in my event-type situations aren’t doing very well operationally and doesn’t seem to have bright prospects (one of them is facing a lawsuit too). I guess the point here for me is that because of these past losses, the price of Avi-Tech had been beaten down by investors/speculators to a point so low that they have essentially assumed these losses are very likely to continue far into the future.

How to Get Rich - The Beauty of Compounding to Investors & Companies

Have you tried using simulation which is the most important factor out of the three? Time, starting capital or return factor?

I think you’ve posed a very valid case here about finding out which is the most important factor. Honestly, I'm not very good at such simulations. But if you've noticed, I've used a factor of 1.5 for rate of return, r and starting capital, P in the case study (i.e $100K x 1.5 = $150K, 10% x 1.5 = 15%). For time period, t, if we use a starting capital of $100K and 30 years (20years x 1.5), the final amount would be about S$1.75M. From this single but likely inconclusive datapoint, it appears that time period and rate of return are the most important factors to consider.

Unfortunately the rate of return probably is one of the least predictable of the 3 factors since there's no way we can be sure we can achieve 10% or 15% return over the long haul. Because of this unpredictability, I thought it is not so useful to state which factor is the most important in the practical sense. However, very fortunately for us, the time period is quite within our control and easily ‘applied’ if and only if we are young enough to start. Then again, achieving a 2-3% return over the long haul is probably easier than say, compounding it for 50 years due to the limitations of being a human. A balanced effort in working on all factors should be the better way to handle the compound equation.

All the 3 factors are highly intertwined and complementary to one another. For example, compounding $100K at 15% for 18, 19 and 20 years will give $1.24M, $1.42M ($180K more from 18th year), $1.64M ($220K more from 19th year) respectively. A good compound rate is important but the effect will be more pronounced if the length of time is extended due to the exponential effect of the formula. Similar relation applies for the other factors.

In conclusion, due to the varying ease of application and unpredictable nature of some factors, it is quite hard to conclude decisively which factor will do most for us in our lifetime. Consequently, I believe the best way to reconcile this is to focus on all 3 factors based on my proposed method to tackle each factor in my post (under The Real Trick – Combining all 3 Inputs).


Good post again to show the different scenarios amongst the 4. It's interesting though that you actually used the book value as a measurement of growth. I thought book value growth is much harder to achieve than earnings growth as it covers a wider spectrum. It is like earnings is the subset of that.

Reply: I used book value in this case because it's easier for me to explain the compounding effect. Also, unlike earnings and cashflows, book value is less subject to fluctuations with time and thus more predictable for use. Besides these, book value is highly related to earnings - A consistently growing book value usually indicates healthy earnings over the period since whatever is left in net income after deducting dividends goes to the book. Lastly, we can also view book value as a rough gauge to the company's intrinsic value if it is to be a liquidated. This means that using book value is not wrong although it may not be the best choice in the end.

Other Articles:
My SG Portfolio 2014 (Top Realized Gains & Losses) and Some Recent Picks
AP Oil - A Neglected but Cheap Stock in Singapore
Our Stocks Investment Philosophy

Thursday 22 January 2015

The Beauty of Compounding in Companies and Its Implications

In my previous post on The Beauty of Compounding to Investors, I've discussed briefly on the mechanics of the simple compound interest equation and concluded that the best way for an investor to optimize its use is to identify each factor (starting capital, compound rate, time period) in the equation separately and work on the weaknesses (especially those that is easily within our control) so that the integration of all 3 factors can hopefully produce an exceptional result. In this post, I'll talk more about this effect on companies and try to relate it to the individual investor.

Albert Einstein on Stock Compound Interest

Case Studies & Assumptions

Let's use some of case studies for Company X (if you are curious about the company's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - Let me know by commenting below or emailing me at when this is done). As usual, to make things simple, some assumptions have to be made for the model:
  1. In the actual case, Company X managed to grow its book value by compounding it at >10% annually for the past 12 years. Here, we assume that this growth rate will continue for the next 5 years. Book value now is $0.25 per share.
  2. Assume book value is a reasonable estimate to intrinsic value of the company and the market price of its stock will converge to its intrinsic/book value at the end of 5 years.
  3. No other forces (inflation etc) are at play that will skew the final results.
4 scenarios will be used here (please note again that book value for all scenarios is $0.25 per share):
  • Scenario A: Market Price: $0.20 (20% discount to book), Growth rate: 0%
  • Scenario B: Market Price: $0.30 (20% premium to book), Growth rate: 10%
  • Scenario C: Market Price: $0.25 (at book value), Growth rate: 10%
  • Scenario D: Market Price: $0.20 (20% discount to book), Growth rate: 10%

Summary of Scenario Results

Shares Investment Results - Dividends Excluded
Scenario Capital Appreciation Results (Dividends not factored in)

Comparing Scenarios A & B, we see that despite paying at 20% premium to book value (for B), the stock investor is still able to turn in better results compared to one who bought at 20% discount to book value (for A) - provided the growth rate is high enough. In this case, a quick calculation shows that a 4.5% growth rate in Scenario B is sufficient to get the same 25% results achieved in Scenario A.

Comparing Scenarios C & D, it is clear that although the purchase price of D is only 20% lower than C and both have the same growth rate, D turns it significantly higher results (much more than 20%). All in all, Scenario D gives the best results. For your info: Company X is currently priced below that of Scenario D now, indicating a better upside if we were to base it on this very simplistic model.

This is a very simplistic view of the compounding effect but it does show the powerful snowballing effect of the compound equation. The key limitations are obviously in the assumptions. In the first place, we can't know for sure whether the book value or 'intrinsic' value can grow at 10% for the next year, save to say for 5 straight years. Also, there are definitely many other factors or uncertainties at play that will affect the final result. Lastly, for most companies, the book value does not equate to the intrinsic value. Even if they do, the market price may or may not converge to this implied intrinsic value at the end of 5 years (it could be earlier or later). Despite these limitations, I believe its good enough to show the compounding effect and its implications to the stock investor.

The Ultimate Approach - Dual Margin of Safety

Margin of safety is an important part of our overall investment framework as discussed in the post on Our Stocks Investment Philosophy. The above exhibit suggests 2 key ways to profit from the stock market. First and foremost, the investor can purchase securities at a price that is currently at a discount to a readily ascertainable intrinsic value as in Scenario A. This discount is in itself a margin of safety. Alternatively, the investor can purchase the security at a reasonably fair price as compared to the current intrinsic value but he or she must be confident that the future prospects or growth is so good that it is sufficient margin of safety for a profit to be made, as in Scenario C above. 

The best approach to stock selection is of course to find securities that meets both criteria or approaches discussed in the previous paragraph - by having a discount to current value and potential growth that can further increase this value in the foreseeable future such that the cushion in price-value gap widens further over time. This is similar to Scenario D in the above table which as shown, give the best results out of the 4.

I will discuss further about the obstacles in execution in the application of the Dual Margin of Safety approach and end off with my proposed solution. Let me know if there's alternative methods or approaches that you've been doing that has been consistently successful ya?

Long Company X - Do you know which company is this?

As mentioned, if you are curious about Company X's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - When this is done, let me know by commenting below or emailing me at :-)

Friday 16 January 2015

How to Get Rich - The Beauty of Compounding to Investors and Companies

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein.
I’m always amazed by the mechanics and impact of the compounding effect. The basic compound interest formula is:-
F = Future value or final value of the investment
P = Principal or the starting capital
r = Annual rate of return
t = The number of years this return is compounded
To let the compounding effect work its wonder, an investor needs to focus on the Starting Capital (denoted by P), Annual rate of return (r) and the number of years (t). Let’s use $100,000 starting capital, 10% annual return and 20 years as baseline inputs for comparisons with other permutations. For simplicity, effects of inflation are neglected throughout.

Effects of Compounding
Compound results table
Effects of Compounding with Various Inputs
As observed from the table and chart, for all cases the value of gains is much more than the initial capital itself. But what can we really learn from these results and what can we do to maximize the compounding effect?
I find it quite worthwhile to classify these inputs based on the level of control we have over them. By identifying them singularly, we can find out which inputs we are lacking and categorically work on them.

Time Factor (t)

As observed above, time is an absolute critical factor for the effects of compounding to snowball the initial capital as much as possible. All of the input invested 7 years late did worse than the baseline input. If we have $100K and can compound 10% for 20 years but we do it 7 years later, our gains is a 57% or $327K lesser! 7 years later is 7 years too late. This is something that we can control only when we are still young. The key is to start investing as early as possible and have the patience to let the compounding effect work. 

To put it into practical perspective, if a 40 year old who earns an average of $100K per year invest with baseline results, he will have an extra $245K by 53 years old. This would mean that his investments gave him an extra 2.45 years of working income. However, if he started 7 years earlier at 33 years old, he will have an extra $570K by 53 years old which also means that he gets an extra 5.7 years of his working income. Why work another 5.7 years when you can actually get the same amount of money with less effort? Retiring a few years earlier is certainly not bad at all!

Starting Capital (P)

The Starting Capital is also important but comparatively less controllable. Different individual profiles will have differing amounts of starting capital to invest. Most of the time, we can’t really control how much we have at the start (especially when we are young). However, all of us have universal control in terms of the proportion of our money we set aside to save and invest. This is a definitely a decision that can be made and acted upon for almost everyone.

Return Factor (r)

Can we really achieve 10% returns per annum for our investments? No one knows. Sometimes its luck and other times it may be because of innate talent. I believe the best way to potentially improve anyone’s returns is through continually seeking and acquiring investment & financial knowledge. This is definitely something within our control. There are many books, articles and videos online and offline that teach us how to make our money work harder for us. Of course, this takes time and effort but I think it’s the only way to handle this factor properly.

The Real Trick – Combining All 3 Inputs

What’s the use if we can earn an impressive return from our investments but we can compound it for only 2 years? There’s also little use when we have 30 years to compound our money when we can only achieve a 2% return. The real trick lies in combining all 3 inputs in the compound interest equation. To do this, we first need to tackle each factor separately by (a) Identifying which factor we are lacking the most, (b) Find out what we can do that is within our control to improve the factor, (c) Work on improving them and (d) Repeat the process again starting from part (a). Let me know if you have other ways to optimize the compounding magic :-)

Note: Just want to highlight that there’s another factor that is not included in this simple compound interest equation. That is the additional cashflows you can add into your investment sum every period. Imagine you can compound 10% in 20 years with a starting capital of $100K and on top of that, you are also able to contribute another $12K into your portfolio annually - Your final value would be $1.36M with a contribution of $340K in total. This is compared to the baseline case mentioned above with $672K final value and $100K contribution.
This post is longer than expected. I’ll talk more about the companies which can continually compound their value through time from an investor's viewpoint.

Thursday 8 January 2015

Avi-Tech Electronics (CT1.SI) – Is Quick Profit Possible?

In my post on My SG Portfolio 2014 and Some Recent Picks, I’ve mentioned that one of my event-driven picks for 2015 is Avi-Tech Electronics. I think price then was about S$0.074 and I’ve accumulated since November at an average price including costs of S$0.699. There are some interesting comments in the post (you should read it here) and I thought that probably it’s good to write a short article about my analysis.

Avi Tech Electronics Stock logo

Avi-Tech Electronics is listed on the SGX and is a provider for Burn-in, engineering and manufacturing services in the semi-conductor & electronics industry. In 2011, It ventured into the Imaging Equipment and Energy Efficient Products by starting 2 subsidiaries to ‘diversify and substantiate long-term growth’ for the company. Guess what happened in the end: since 2011, the company began incurring losses largely due to these same subsidiaries and management has finally decided to discontinue these operations just a couple of months back. Originally, the classification of this type of purchase in my portfolio (see post for more details about this) do not require intensive analysis – so I’ll try to keep things simple here. The following data are based on my 30 Dec 2014 post:

Price = S$0.074
Shares outstanding = 342,422,096
Market Cap = S$25.34M
P/E = NA (losses)
EV/EBIT = NA (losses)
P/NTA = 0.63

Investment Thesis

The results in this classification of stocks depend a lot on corporate events which in some sense serve as a catalyst to close up the price-value gap, hopefully in a fairly short period of time. My investment decision is premised on the following: 
  1. The management has destroyed huge value over the years from the 2 loss-making subsidiaries. Many shareholders could have loss confidence with management's ability and decided to sell / cut losses.
  2. The poorer fundamentals and financial results combined with the inclusion onto the SGX watch-list due to 3 consecutive years of pre-tax losses has led to a stock price decline that is likely over-exaggerated.
  3. This exaggeration led to a fair degree of undervaluation which also means a potential investment opportunity to the shrewd analyst.
  4. Directors have been mopping up shares recently with their own money and to that extent, agreeing with my view that the stock price might be undervalued.
  5. The disposal of subsidiaries which are main contributors of past years' losses may improve future earnings at least in the short term and this may prop up the market price.

Key Risks / Uncertainty

Management indicated that they will “continue with its plans to seek new areas of growth whether through mergers and acquisitions, or any structured transaction or business, which will add value to shareholders.” Has management really learnt their lesson from previous experiences? Are they capable enough to continue ‘adding value’ through acquisitions? Personally, I feel its foolish for them to do that considering their core business ain’t doing as well as before too (more details below).

Also, we can’t deny the fact that they are in a difficult semi-conductor industry which presents a challenge to the management (that is perhaps why they insist on growing through acquisitions etc) and a risk that the investor need to be wary of.

Safeguards and Checks – In case things do not turn out well

Like I say, the need for intensive analysis is not really required for the event-type part of my portfolio and I hope to realize some profits in a reasonably short period of time. However, as a safeguard, I better ensure there’s some sort of margin of safety if things don’t work out and I might have to hold on to it for a longer than expected timeframe. Since this will be a minor position in my portfolio, a brief analysis should be sufficient.

Financial Position

The balance sheet is generally cash rich with net cash equivalents of about S$23.5M which compares favorably to the market cap at S$25.3M. Book value is about S$40M. If the company is liquidated now, I believe we can get back more than what we pay now. Of course, if management continues eroding value by doing foolish expansions, the intrinsic value on a liquidating basis may drop below our price paid in light of such later developments in the business. 


Avi Tech Electronics Stock Financial Results
Avi-Tech Electronics Financial Summary
I’ve cleaned up the effects of the loss-making subsidiaries in the above table and it is clear that these subsidiaries have indeed eroded earnings between 2011 and 2013, before management decide to discontinue operations in 2014. The core operations haven’t been doing well too considering that they also have registered some losses between 2012 to 2014. Core business revenue has declined drastically from S$70M to S$23M over 7 years.  However, keep in mind that the bulk of the negative earnings is attributed to the subsidiaries (contribution by subsidiaries is -S$12.8M compared to +S$1.7M for core business from 2011 to 2013). 


Not surprisingly, thanks to these loss-making subsidiaries, share price has declined more than 60% since 2011. The discontinuation of the subsidiaries has stemmed losses greatly and results in 1Q2015 shows a positive profit. Could there be turnaround which can lift share price higher? No one can say this for sure.

Avi-Tech Electronics 5 Year Stock Chart
Avi-Tech Electronics 5 Year Stock Chart
Let's use 2010 and 2015 results for comparison since in both years, the loss-making subsidiaries are non-existent. A back-of-the envelope calculation shows PER of 2010 is about 15.6X while forward PER of 2015 appears to be about 9.1X (I annualized 1Q15 earnings per share of S$0.002 here as an approximation). Assuming all else remains the same, this could be another indication that share price decline has been exaggerated and the market probably has not factored in the positive effects from the disposal. If valuation in 2010 is any guide, the market price should be priced around S$0.12! Of course, I’m not saying these assumptions are reasonable but at least it gives me some level of comfort here knowing that I'm not buying at a ridiculously high price.

Because the earnings has been quite unstable, probably the balance sheet can give better insights about its intrinsic value. Taking a haircut of 50% to PPE (NB: this part of the balance sheet is throwing in some S$500K-S$700K rental income annually), 25% to inventory and 10% to receivables, we get a liquidation value of S$0.094 per share as compared to the price of S$0.074. (Potential Bonus 1: I did not include the proceeds that the company may receive from the disposal of subsidiary in this valuation).


A high price can turn stocks of good quality businesses into a speculative purchase and likewise, a low price can turn a speculative stock into an attractive investment. My opinion is that Avi-Tech belongs to the latter. Considering the pros and cons, I think the low price coupled with the existence of potential catalysts make the purchase of Avi-tech too attractive to be denied by the security analyst. However, the risks mentioned above also means that the sizing of the position in the portfolio should be kept relatively small - just in case management screw things up again. (Potential Bonus 2: we already ensured there's some margin of safety to absorb unfavourable future developments but what if by some freak nature, the future acquisitions are so successful that future earnings improve dramatically? This is definitely not accounted for yet).

Some Final Thoughts

Due to it’s classification in my portfolio & unless there’s any clear-cut change in circumstances, my guess is that I will take most of my profits (if any) within the next 12 months. I mentioned that my average price purchased including costs since November ‘14 is S$0.0699. Price now at S$0.078 would mean that my current returns is about 12% in slightly less than 2 months. Obviously this is not the best business in the best industry and I have the urge to take my profits initially when it was at S$0.08. After some deliberation, I figured that my estimate of S$0.094 is really a minimum valuation which is so conservative to the extent that it is a reasonably dependable guide. Moreover, one of the directors bought back shares a couple of days back at about S$0.078. Maybe somewhere around S$0.09 I can consider trimming my stakes. I would be more than happy to get some opinions about this.

PS: I’m surprised that I took about an hour of analysis before my decision to purchase Avi-Tech but it took me more than 3-4 hours to write it in this blog!

Long Avi-Tech Electronics  (CT1.SI)