Wednesday, October 26, 2016

My Thought Process When Selecting Stocks

I've been wanting to write on this for some time but find it incredibly difficult to organize my thoughts and do so.

When I saw fellow bloggers write about their thought process on their preference and methodology on selecting stocks, it helps a lot because there are so many ways and path that we can reach to Rome.

- Azrael talks about his method of valuing stocks using fundamental analysis here.

- Chin Wai talks about his method of valuing stocks using Price to book value here.

- STE talks about his method of valuing stocks using the regression method here.

When I was at the sharing session a few weeks ago, someone came to ask me how should they come about to select stocks. It is a very common yet difficult question to answer because there are so many ways that you can come across to look at it yet giving that answer was not the easiest for me. I was dumbfounded.

Since then, I came home thinking hard over the next few weeks how should I translate this thinking into something practical that many people can relate to. If we talk about using the low price to earnings or low price to book value, everyone gets the concept but they will find it difficult to apply in real life. If you talk about using the screening filter, again it's not scientific and coded about using what sort of information is the best.


Putting on my thinking cap


My Thought Process

Here, I am going to attempt to translate my thought process into something mathematical, something which everyone is familiar with. I thought having such thought process is important because it gives me an indication and guidance when I am faced with many hurdles, temptation and questions and being able to justify why I select certain companies at certain times that meet my criteria becomes the utmost importance in my investing journey.

Before I begin, I need to stress once again that this is purely based on my personal thought process so any individuals could disagree or have a different opinions and it totally make sense.

                                                                     X + Y + Z = Total Returns

where X represents the Dividend Yield (%), Y represents the Dividend Growth (%) or Capital Gain (%), and Z represents the valuation factor.

Assumptions

X - These represents the dividend yield (%) of a company which is pretty straightforward. There are some questions on whether one should use the historical or forward dividend yield and I will address that in a while below but for this purpose I will use X as a determinant for historical dividend yield. This is a known factor which you and I and everyone else know about it.

Y - This is the crucial part here because almost everything revolves around this factor and the amount of competency that you have and put in researching and forecasting will determine the total returns that you will get. Here, I am putting this to represent the dividend growth (%) or capital gain potential (%) because for simplistic reason I am assuming that if the company has positive dividend growth, it assumes that earnings and cashflow are better and thus the share price would reflect a higher price in order to justify the same yield as they have previously.

For example, if I assume that Singtel is going to increase its dividend from 17 cents to 19 cents next year because earnings and cashflow are better, that would represent a 11.7% increase. This means that I will mathematically put Y = 11.7% in my head and assume that the market would account for a corresponding 11.7% increase in the share price. It will not be exactly the same amount, but the theoretical concept is usually the case.

Similarly, Y can also be attributed to negative growth. A very good example in recent case would be Keppel or M1, which is an extremely hot topic these days.

For theoretical example, should M1 decides to cut their dividend from 15 cents to 13 cents next year, this represents a (13.3%) decrease. This means that I would attribute Y = (13.3%) and would account in my head that I am expecting market to discount the share price by the same percentage point.

To reiterate once again, to be able to forecast Y requires many years of competency of understanding the business and the industry.

Z - This is where valuation would come from. Valuation can come in many forms and I will not be going into the detail here. If you are interested to learn more on valuation, you should look out for Prof. Asmoth Damodaran blog as he detailed out each individual valuation methodology and dissect them to the very detailed.

The general idea to take away here is that if your X and Y sucks, you can still get a good deal out of your investment assuming your Z value is high. There is no hard and fast rule on what you should be putting for Z but generally the cheaper the valuation the higher the value of Z be. On the other hand, if your X and Y are good, the Z value is usually very low because you will see companies that are stretching at overvalued proposition. Shengshiong and SATS are two very good example of such in my opinion.

Total Returns - When you combine all three factors, X + Y + Z, you should ideally get a rough idea of returns that you are expecting for. This can vary among individuals depending on their appetites and competencies. For myself, I am expecting a total return of 10% / year for each investment I made. This means that I usually have to work out between the three factors which of those that I wanted to focus on and get a better clarity. 

My Favorite Strategy

Obviously, the best you can get out of your returns is through achieving a high X, high Y and high Z. While they are not impossible to find, they are not easy to detect as well because for most of the part the Y and Z function are unknown factor where individual competencies and time investment put into the research matters. So I won't be stating the obvious for the purpose of this exercise.

1.) High X + High Y + Low Z =  In Excess of 10%

This quickly becomes one of my personal favorite strategy in recent times because I've been looking for companies which are catalyst driven. What this means in terms of Y is that I am usually expecting earnings and/or dividends to be part of the catalyst which would eventually drives the share price up. This is usually a short term holding and as soon as those catalysts are executed and announced in their financial results to the public, I will divest them for a profit taking.

In my current portfolio, Micro-Mech and UMS (both recent additions) falls under this category as both companies owns good balance sheet, good cash flow, high dividend yield and a stronger semi-con industry demand set to grow in 2017/2018 means that demand order will grow.

2.) High X + Low Y + High Z = In Excess of 10%

Sometimes, I find it difficult to find companies which displayed the above attributes for short term profit taking. Hence, I will delve down to the next option.

This is usually a long term holdings because of the high dividend yield and decent valuation, which warrants a hold in the portfolio.

In my current portfolio, Ireit, First Reit and Ascott Reit would fall under this category due to the nature of the structure of Reits they are in. All of them provides high dividend yield and a decent valuation, though for Ireit and First Reit I am still secretly hoping for a high dark horse Y factor (I spoke of this in my sharing seminar on the self-reinforcing cycle).

3.) Low X + Low Y + High Z = In Excess of 10%

Some of the developers which I have bought in the past would fall under this category. A good example would be companies such as CDL and Ho Bee, both which I have divested since, are providing low yield with no catalyst in sight but their valuation is so cheap that at times they might warrant a buy and keep.

Personally, I'd prefer to avoid such companies for now because of my biased preference towards a high dividend yield (high X) these days but I will keep an open mind should such opportunities arise.

4.) Low X + High Y + Low Z = In Excess of 10%

I personally suck at this strategy where a company could display a potential growth story which would eventually push the valuation even higher. I just simply don't know how to work out at such strategy so it is extremely rare that I will own such companies in my portfolio.

Osim, Super Group, Sarine, Straco are example of such companies which would fall under this category and as you can see most of them have tripled or quadrupled in value if you can get it right.

Summary

This is just some of the things that is going through my head when I invest that I am sharing with.

As mentioned earlier, everyone has a different preference profile towards their investing strategy and it is important to find your mojo that suits your profile than following others. For instance, my biased preference towards a high dividend yield (but must be sustainable) to suit my cashflow needs may not suit others who feel that they want growth in their companies. 

I hope this helps someone to have things to think about in their head when they are choosing between a few stocks to invest in with their money.

15 comments:

  1. Hi B,

    Just a few comments I'd like to make on your post. First of all, the formula you state is X + Y + Z = Total Returns. However, you have defined "X" as historical dividend yield. My point is that since it is "historical", how will this factor into the total returns profile? What investors should look for is the forward dividend yield, and this has to be estimated very carefully based on an assessment of the underlying business and the economic conditions governing the industry and company. Many a times, historical yield has proven to be a poor indicator of future returns, especially for companies which have fallen on tough times. Using "X" as you defined it would be misleading as it would give the investor a false sense of security that he can attain a high dividend yield when reality may prove otherwise.

    Second point - the "Y" which you stated is the dividend growth rate. Please note that a rate is simply an increase (in % terms) of the absolute dividend per share and ideally, you should compute the actual dividend and divide it by the share price to obtain an estimate of the forward YIELD. An example would be a company which pays 10c this year. If you think the growth is 10% then next year's dividend can reasonably be expected to be 11c. If the share price is $1.00, then the expected yield would be 11% compared to 10%, so you cannot use 10% as "Y", instead you should use 11% as your return calculation. Capital gains % is subject to the share price and therefore cannot be reliably computed, therefore I would safely relegate this to "speculative" and assume it is zero. Therefore, you are left with just Y, the forward yield.

    As for Z, I do not really comprehend the concept of "valuation" being part of the total return equation. Does it meant that if a different valuation methodology is used, this means that your total return expectation would be different? If so, then the investor would be able to use the most optimistic valuation method and deduce that he had significant potential upside, which is a rather dangerous way of assessing an investment as the aim is to seek margin of safety. Valuation is also subjective and is based on a myriad of factors.
    (Continued)

    ReplyDelete
  2. What I would propose is a total return equation based on just two variables. These will be X + Y = Total Return, and is measured based on X being the forward dividend yield and Y being the expected capital gains. X is measurable to some extent and can be estimated, while Y should ideally track the growth in the FCF of the Company as well as the profitability. The total return of any investment based on a long-term horizon should be around 7% to 10% - anything above this would be considered extremely high. If we go by this definition, then companies with high dividend yields and no or low growth would have high X but low or zero Y. This means you solely rely on the dividend yield for your returns, and they will compensate you for expecting no growth as the Company cannot deploy cash efficiently.

    Another point I would like to mention is that if a Company decided to raise its dividend, it may NOT always translate to a share price increase. This is because the Company could be unable to properly deploy its cash to generate high ROIC and is therefore paying out more cash to shareholders, thus eroding ROE and ROIC. Therefore, X would increase but Y (expected growth in FCF and profits) would diminish, thereby making total return constant compared to a Company with low dividend yield (Low X) and higher growth in FCF (high Y).

    Companies with high growth prospects normally can achieve a high Y (capital gains), but here an investor has to ask if there is a lot of optimism already priced in? If so, then Y could be negative when actual results fall short of expectations. The low X (forward yield) may not be able to compensate the investor for his capital loss in such situations, which we may label as "Value Traps" or basically "Valuation Errors".

    I could go on, but will stop here as I think I've made several points worth discussing.

    Thanks!

    ReplyDelete
    Replies
    1. the Z make sense here. it is putting that as a variable in that equation. you have to understand this is philosophical. once you understand that then it becomes clear that this is the way you think as well and should focus less on the meta of how you compute it.

      Delete
  3. Hi MW

    Thanks a lot for your detailed explanation and thoughts on it. I've read all of them and I'll see on how to dissect to reply each part of those.

    First of all, I'd agree with your overall X + Y methodology with X being the forward yield and Y being the expected capital gain. Having said that, I'm trying to dissect a little further by using X the known factor so common folks can understand the part on the obvious vs the not obvious. My part about the X + Y would indirectly indicate forward yield, which goes back to the same thought as yours. I wanted to avoid your preferred X + Y in explaining in order to avoid giving the impression that both X and Y are unknown variables, which they actually can be split further.

    On your comment about Y being the capital gain expectation that its subject to the market forces, I'd also agree that they are not within our control and thus can't technically put a value to it. I'm also coming from your view that this should represents expected capital gain but this can vary, depending on market forces and the general state of the market sentiments.

    The valuation part for Z is indeed a bit tricky here. I wanted to give an impression that a so so company can still make a decent "investment" if one bought them at a decent valuation. By means of investment i am talking about solely making profits and nothing else. I was originally planning to leave the Z part out but then it wouldnt make sense just to have X + Y as an investment if that company has super rich valuation.

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  4. All in all, thanks again for the thought and its very valid for discussion purpose.

    ReplyDelete
  5. Hi B,

    It is a conincident that I am also reviewing my investing journey. Have u tried looking at your track records of the different combinations of X, Y and Z and which one works out for you
    Best?

    I realize I sucks at playing cyclical, (a bit of regression to mean) although I might get the survivability and "leader" status right, I seldom get the "bottom" right. It's a bottomless pit. Abut the learning does help us to stay away from the peak...

    Cheers ...

    ReplyDelete
    Replies
    1. Hi SI

      Ahh I guess all of us are trying to find our best mojo everyday :)

      Yes, I've found my best combination strategy and am right now sticking to it. They are dynamic though so it will keep changing and hopefully for the better.

      I think for as long as we keep sharpening our tools and staying away from our weaknesses, we should do fine in our investing journey, caveat here.

      Delete
  6. B,

    When I read your post, the first thing that struck me is you are definitely left-brained ;)

    Then I realised you are sharing YOUR own thought processes so I restrained myself ;)

    For right-brained people like me, imagery and the fuzziness of words hold greater sway than the supposed "precision" of numbers and mathematical formulas:

    Asset play

    Cyclical play

    Dividend play

    Turnaround play

    Growth story

    Stalwart anchor (yes, I got read Peter Lynch too)


    But then, I'm only a salesperson - must convey word imagery so customers can visualise and convince themselves to buy... LOL!



    Psst. I like you have an exit strategy; you are no "stamp collector" ;)

    ReplyDelete
    Replies
    1. Hi SMOL

      Hahaha, regardless black or white cat, who catches the mice wins right!? :D

      I don't underestimate the power of salesperson. They have lots of insider information which can be put to advantage in investing. And they are usually gungho and confident about their style. I like it!!!

      Delete
  7. Very good method, thanks for sharing

    ReplyDelete
  8. Hi B,
    Great detail of your thoughts, though as you said , valuation is rather subjective and many roads reach to Rome. ..having good analysis of thought on the valuation is important as to pay the right price (at least base on our own assumptions ).. although we do understand that small change on certain variable would have much impart on the value of that particular stock. .eg.growth or discount rate at DDM or DCF etc..
    Cheers.👍

    ReplyDelete
  9. Just sharing .... a multi-millionaire golden rule.

    http://koonyewyin.com/2016/06/04/koons-investment-lesson-2-my-golden-rule/

    It's easy to understand, but difficult to follow.

    ReplyDelete
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