Wednesday, February 28, 2007

How to select growth firms

Lately, companies that reported strong growth in sales and profits were rewarded with higher stock prices. Hence, analysts and investors are currently paying close attention to the latest financial results announcements, hoping to catch those stocks early at a low price.

Benjamin Graham defined a growth company as a company that has performed better than the industry average over a period of years and is expected to continue to do so in the future. As earnings potential is the primary driving force in stock prices, our focus will be on the potential growth in earnings, which has yet to be reflected in the current price.

When investors invest in growth companies, they are hoping to invest in companies with products or services that are in high demand and have an edge over the competition.

According to W. Chan Kim and RenĂ©e Mauborgne in their famous book, “Blue Ocean Strategy'', companies in blue oceans, where there is still ample untapped market space, have the highest opportunities for demand creation and profitable growth. Normally, they tend to be the best among their industry peers and place equal emphasis on value creation and innovation.

According to Warren Buffett, growth companies have long-term pricing power and sustainable moat. The long-term pricing power refers to the ability to increase prices even when product demand is flat or the ability to achieve large volume increases with only small additional capital investment.

A sustainable moat is regarded as the entry barrier that current competitors and potential entrants find impossible to break. Companies with the above two characteristics will normally show high growth in sales and good profit margin.

Recently, companies with great businesses and fast growth were traded at price levels that might not be unsustainable. Investors need to pay attention to the price that they pay and the expectation of future growth. In reality, it is impossible for a true growth company to exist for an infinite time period in a relatively competitive economy.

Therefore, the entry price for a growth stock is crucial. The time to purchase is when it is still on sale, and not when it’s already at the peak where everyone seems to own a piece of it.

How do I know whether this stock is considered a growth company?

One of the common methods used by analysts for identifying growth companies is by tracking the company’s quarterly financial results. Again, strong sales and profit growth are the two most important characteristics of a growth company. If a company is able to show consistent growth in sales, this implies that it is expanding its production capacity and activities.

The table shows the quarterly financial results of Tong Herr Resources Bhd. Over the past three quarters, from Q106 to Q406, it reported strong growth in sales and profits on a quarter-on-quarter basis as well as year-on-year basis.

As a result of lower profits reported in Q205, Q305 and Q405, its stock prices tumbled from a high of RM4.30 in early 2005 to a low of RM2.30 in February 2006. Since then, due to the strong growth in sales and profits, its share price has recovered to the RM4-level again recently.

Investors need to study a company’s financial performance to determine whether the potential of future growth has been fully reflected in its current stock price.

As a result of the extrapolation of the recent performance, when the market is already high, our analysis will tend to be over-confident, which would lead to the decision to buy or sell stocks at the wrong time.

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Wednesday, February 14, 2007

Relating earnings to stock price

Consistent growth in sales and profits reflects strong earnings power of a company. Investors need to check the company's financial performance before selling a stock.

How do I determine the earning power of a company?

As a result of higher investor confidence and stock prices, the market capitalisation of certain blue-chip stocks has surged to new highs.

Some analysts have started to revise upwards the target prices of these companies as a result of higher market valuation. It appears that the prospects of these companies have “suddenly” improved within a short period of time.

When we analyse their fundamentals, their sales, earnings or production capacity are about the same compared with the previous year's. Although certain companies may have shown better prospects due to some merger and acquisition activities, most of them have shown little change in their fundamentals. Yet, their stock prices have surged by more than 100% in less than a year!

We will not pay RM5,000 for a hand phone that is worth only RM1,000. However, we are willing to pay 5 to 10 times above the intrinsic value of a company during a bull market.

This may be attributed to our expectation of the future prospects of these companies. We may be able to judge the real value of a hand phone, but we have difficulty determining with certainty the future prospects of these companies.

Intrinsic value of the company
The fair price we need to pay for a stock will depend on the intrinsic value of the company. An investor needs to know the intrinsic value before making any purchase. According to Benjamin Graham in his book entitled Security Analysis, intrinsic value is an elusive concept.

He defined it as the price at which a stock should be sold if properly priced in a normal market and the value being justified by the facts, for example, the assets, earnings, dividends and definite prospects.

He also said the intrinsic value of a company could be determined by its earning power but admitted that it was very difficult to establish with precision a stock’s real earning power.

We can only provide an approximation on whether the value is adequate compared with its market price. However, we are unable to determine the exact intrinsic value.

Graham defined earning power as a combination of actual earnings, shown over a number of years, with a reasonable expectation that these will be approximated in the future. A company's strong earning power will imply that it has the potential to generate higher sales and earnings in future.

If the stock price of a company is highly correlated with its earnings, improved earnings will contribute to higher stock prices. If the current stock price does not reflect the strong earnings potential of the company, buying the stock at the current price can contribute to higher capital gain.

Method to determine the earning power

The following is one of the quantitative methods in determining the earning power of a company suggested by Graham. From the earlier definition, in order to check a company's potential earning power, we may need to trace its historical earning and sales performance.

The table shows the historical earnings of Transmile Group Bhd.

The consistent growth in sales and profits in the table reflects Transmile's strong earning power over the past six years.

Its stock price has also surged from the average price of RM1.81 in FY01 to RM12.45 in FY06. Any investor who had bought this stock at an average price of RM1.81 in FY01 should have made a handsome gain of 588% within a five-year period.

Unfortunately, most retailers would have sold this stock at around RM5.00 in FY04 as not many investors were able to resist the temptation of locking in their gains.

Given that most investors seldom check on the actual financial performance of a company, the decision to sell a stock would always depend on its original purchase price rather than the earning power of the company.

As a result, they usually miss the golden chance of making handsome returns from good fundamental stocks.

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