Stocks I don't like

As a value investor, looking to buy solid, undervalued stocks when the markets go into a tailspin, these are the things I avoid.

Technology

Building a sustainable competitive advantage is meaningless in the tech sector, where industries quickly change to become unrecognizable. So I would not buy technology stocks based on low valuations or high market share (e.g.: Microsoft and Cisco today, Nokia several years ago). If I was to buy tech, it would be as part of a growth strategy: in a bull market, with a stock at all times high, with growing sales and their new products that are changing the world....just remember to leave once the party is over: today's hot product is tomorrow's junk....

I also like the idea of avoiding any product/service whose input and output is information (See 'Software eats part of the world'). e.g.: credit cards, newspapers, TV, bookstores.

Change is bad for value investing.


Banking and Finance

Banks are a black box. They make money by lending it out and hoping people can pay back. There is no way to judge the quality of earnings from their cashflow statements. In addition, banking crises occur regularly enough that we can consider them a part of human nature.

So for a long term investor, don't buy when times are good, as the next crisis will hit and drive down the share price of your bank. And don't buy when times are bad, as they can go to zero. Bill Miller beat the S&P for 15 straight years, then in 2009 he "bought ‘cheap’ financials after the credit crunch, but later they got even cheaper". Like Bear Stearns and AIG. He resigned a few years later.

Investment banks are worse, some seem deliberately designed to store risky assets until they blow up.

How do you know which banks are good and which are bad? If Bill Miller and GIC cannot get it right, what makes you think you can?

REITS

I've two main objections to REITS:

• First, Singapore Reits must payout 90% of their income as dividends. So they are in perpetual debt. Meaning that you are taking for granted low interest rates and access to finance....forever. Ironically, I think they would be better long term investments if they could use their income to payoff their debt.
  
• Second, how many REITS bought property at low, low prices during the 08/09 market crash? I cant think of any. A-REIT even made a rights issue at the bottom of the downturn. Some people may even get the impression that REITS are not run to benefit their shareholders.
  

Stocks I'm interested in

Still waiting for a recession, and drawing up a list of stocks that I want to buy. And others that I still have to look in to (*).

Dominators: Buffet-like companies, with large market share and only a handful of competitors, these companies have a sustainable competitive advantage in their industries. These stocks will never go to zero, and could rise 50-100% from bear market trough to bull. Might be possible to hold these stocks forever:

• Coca Cola: Buffet's largest holding. Strong distribution network gives it a moat.
  
• UPS: Only a 2 or 3 competitors worldwide, and one in the US. Buffet also holds some.
  
• Diageo: Largest spirits producer in the world , and a cashcow; sales nearly double its closest competitor.

Local Blue chips: Big players in Singapore or the region: Also will probably never go to zero, though they do not have a sustainable competitive advantage. Usually rise 50-150% from bear market trough to bull:

• Diary Farm: Large player in Asia supermarkets & convenience stores. Low debt, generates cash.
  
• SIA Engineering (*). Or maybe STE (*).
• Raffles Medical Group (*), or possible its overseas competitors (eg: The hospital in Thailand...).
• A property development company (freehold property only): Wheelock, SC Global (*), or CDL (*). Wheelock has historically been the most astute in its timing, but has been doing nothing for the past few years. Check the others, esp. their debt, and how their properties are values on their balance sheet.
• Eu Yang Sang: Low debt, and a long history of being profitable and generating free cashflow.
• Goodpack (*): Large share of natural rubber shipments, and gaining share in artificial rubber. Has it started generating free cashflow yet?

Small fry. Risky, but I try to target those with few competitors and good balance sheets, to avoid the ones that go to zero. These are also very illiquid. May rise 2-4 times from bear to bull.

• Petra: Love their branded consumer distribution, as a producer and distributor of Chocolates in Indonesia. Not so keen on their cocoa processing.
• Silverlake Axis (*): Handles a large proportion of banking transactions in SEA. Clients have long term (3-5 year) maintenance contracts, giving a stream of future profits.
• HDD industry: There is a small company which makes a large percentage (worldwide) of the HD actuator arms - forget its name (*). Alternatively, Seagate may be worth looking at. Always a large risk of obsolescence when buying tech: this is a bet that HDDs will still be around to hold information in the cloud.
• 2nd Chance Properties (*): Plans to change to the property business, by buying commercial property in a downturn. Interesting idea, though I have not looked at the company yet.
  

Punting:

• China Mingzong. Currently selling at 5X earnings, (as far as I can make out) in a non-cyclical industry. They don't have pricing power, but their industry should grow. Largest competitor may be a fraud, no guarantees about this one either. May buy a little with money I can afford to lose in the hope it goes up 5-10X in the long term.
• AirAsia: Don't know where to classify this one, they are in a new industry...in fact they are the industry - no one seems to be able to replicate them profitably after years of trying. But they have fuckloads of debt and unimaginable future capital commitments.
  

Lets see if 2012 brings a chance to buy....

Diageo (DGE:LSE)

World's largest spirits maker. They make Johnnie Walker, Smirnoff, Guinness, Baileys among others. Most of their products are number 1 or number 2 in their markets:

Competitive Advantage

Diageo's worldwide sales are twice that of their nearest competitor, Pernod Ricard. The third (or forth) largest producer, Barcardi, is privately owned and does not disclose sales. Next come 'Brown & Foreman', and Beam (formerly Fortune Brands), which have 1/3rd or 1/4th of Diageo's sales.
Notes:

• Diageo reports in Pounds, currency conversion values above from here and here.
• Diageo owns 1/3rd of Moet Hennessey.

Diageo's margins seem slightly lower than their competitors:
Notes:

• All exclude excise and corporate taxes, except possibly for MH.
• All include discontinued ops except Beam - the difference is negligible
  

MorningStar believes that Diageo has a strong distribution and sales network in North America (33% of sales, 44% profit in 2011), "resulting in operating margins in North America in excess of 35%, well above the firm's consolidated margin in the high 20s, and higher than most of its competitors."

Cyclical

From the above graph, operating Margins of all companies were affected by the 08/09 recession.

Sales did not fall however (Organic sales growth of zero in 08 and 2% in 09). Organic sales generally rise by high single digits (5-8%) during good times.

Business Model

The company is a cashcow, regularly generating profits and free cashflow year in year out:

How much of their costs are fixed, and how much variable?

From the above graph, many of their costs seem seem to be variable, not fixed:

• I'm not sure how staff costs can be variable.
• For marketing: I guess when times are bad, advertising is cheaper.
• Cannot tell what their 'Others' cost is. 2009's dip can be partially explained by a 1bn loss from the Pension scheme.

This an asset light business. There's very little depreciation or operating leases, and most of asset are brands (intangibles).

High inventories:

• Morningstar notes that: "About one third of Diageo's volume ... is derived from maturing products, which can sit in inventory and age for up to 30 years. ... Diageo expenses these input costs on an actual usage basis, meaning that it could be 10-30 years before today's cost inflation affects the income statement. Therefore, we suggest investors look closely at cash flow in addition to earnings when valuing Diageo."
• They have about 2.7bn of Maturing Inventories, over 80% of it intended to be held more than one year.
  

Beyond future 0-8% organic growth, acquisitions are required. Diageo looks for companies with "strong local routes to market":

• Worldwide: MH is most desirable, but not for sale. Diageo is currently negotiating to buy Jose Curevo.
• Diageo is restricted from entering into Tequila, Cognac and Chapagne, due to their agreements with HM and Jose Curevo. There may also be anti-trust restrictions if it ends up owning to many popular brands in the same category.
• Recently bought a 23.6% stake in Halico, Vietnam's leading spirits maker for £33m. Bought Mey Icki, which controls 80% of the market for Raki, at £1.3bn, at 9.9 times 2010 EBITA.

Balance Sheet

£6.7bn long term debt. Slightly over 3 years profit (before-tax).

Pensions liability underfunded by £838m as of June 2011:

• Their actuarial assumptions (p130. eg: salary increase, inflation) look OK.
• Discount rates are 4.9 to 5.7%. About 40% of the fund is in equities, with an expected return of 8.3%. Probably OK.
• The group expects to make 163m contributions in 2012.

Negligible operating leases: 368m over the next 5 years.

Cashflows

Net Cashflow from Operations (basically CFO minus tax and interest) is usually higher than their reported profit. Outlays on Cash Flow from investment are usually quire small:

Conclusion

I would buy in a recession.

SG Property Development Rules

New (and existing) rules applying to property developers (BT Fri 9th Dec, front page, Kalpana Rashiwala).

Old rules:

• Any developer buying a Government Land Sale (GLS) residential site had to complete development in 5 years (no time limit on sales).
• When buying a private sector residential site, foreign developers have to obtain a Qualifying Certificate, which requires 5 year limit for the TOP (development) and another 2 year limit on sales. Any developer with even a single foreign shareholder is considered 'foreign', hence CDL, Capitaland & Wheelock face these limits. Only local, privately owned developers (Far East, Hoi Hup) were except.

New rules:

• For any site bought after Dec 8th, must develop and sell all units within 5 years. Otherwise they must pay a 10% additional buyer's stamp duty (ABSD) at the end of the 5 year period (with interest).

My thoughts:

• Levels the playing field between private and publicly owned property developers.
• Forcing developers to sell during a downturn may exacerbate it. Every last unit must be sold within the timeframe. Would these measures be removed? Retroactively?
  
• I used to like Wheelock due to their astute market timing. As they have no undeveloped property in its landbank: they are now restricted to developing and selling any new land withing 5 years (previously it was 7).
• SC Global may benefit, as they have a large bank of prime freehold land bought before the restrictions came into force.