In Search of Great Stocks, Part I
A good start when searching for great investments is to look for a good company and then buy its stock at the right price. Some investors use gut instinct, which often times just isn’t accurate enough. Some use check lists which might have too many details and can cause investors to miss some great opportunities because of small defects which don’t have a material effect on companies’ performance.
In this article, I will introduce you to my method of how to find a good stock using "big picture analysis.” Let’s start with 3 qualities a good stock should have.
• Large future growth
Many investors love this quality, especially Peter Lynch, because on average growth stocks can return very large capital gains. When speaking of growth, I mean future growth, not past performance. I look for at least 25% EPS growth annually over the next 3 years. Usually, growth comes from growth of the industry, expanding into a new market and/or gaining market share from competitors. A strong company that has a large market share and operates in a mature industry can’t be considered to have this quality because there is no room for growth. Many Chinese stocks exhibit great growth. (Cost cutting or price increasing which generates bottom-line results is another way to generate EPS growth, even though sales volume doesn’t increase.)
• Great cash flow
I look for companies that don’t need a lot of money to invest in accounts receivable, inventories, or expensive plants or equipment to grow their business or just sustain their competitive position. Sectors in which we can find this quality are, for example, retail businesses, online businesses and the insurance sector. These kinds of companies can have excess cash to pay dividends and to make share repurchases.
• Low competition
A company which operates in a highly competitive industry can have difficulty sustaining profit margins because when industry players have a high margin they attract many new competitors and/or cause old players to expand capacity. When there is more supply in the market, price will be decreased due to price wars. A good company needs to have a high barrier to entry, an established distribution network, differentiated products, a recognized brand and/or cost leadership to make it difficult for others to compete.
A company does not need to have all three qualities to be worth investing in. Just 2 out of 3 qualities are fine because finding a company that has all 3 qualities and has an attractive valuation is like looking for a needle in a haystack. From the three above-mentioned qualities, we can divide worthy-to-buy stocks into 4 groups as shown in the diagram below. I refer to it as my “Stock Selection Diagram” or “SSD” for short.
• G-CF stock (Large future growth with Great cash flow)
Usually, a high-growth company needs a lot of money to invest in new equipment, more accounts receivable, and more inventories. Where we can find G-CF stocks which do not need to invest a lot of money is in online businesses, retail businesses, the insurance sector and so on which do business in emerging markets such as China and other Asian countries, except Japan. Because this group of stocks does not need a lot of capital, new competitors can easily enter the industry and this can result in high competition. If investors can’t find any reasons to believe that a G-CF stock has special advantages over competitors which will enable it to become a great company in the future, we shouldn’t make a long-term investment in it. A good time frame for holding this kind of stock is not more than 3 years and the suitable strategy is hit-and-run. The last tip on dealing with this kind of stock is to keep an eye on many G-CF stocks because this is the group of stocks that has great potential to become great stocks if they become big enough to establish cost leadership, distribution power or brand recognition.
• G-LC stock (Large growth with Low competition)
A G-LC stock can grow significantly while sustaining a high margin but the downside is it needs lots of money to keep business running. In the growth stage, we shouldn’t expect any dividends from it, moreover, we should prepare for a lot of dilution along the way. Examples of this kind of stock are distributors, which need to invest a lot in working capital and establishment of their distribution network, and energy/utility companies, which need licenses from the government. When investing in a G-LC stock, investors should look closely at cash flow in the cash flow statement to determine whether it is enough for the company’s investment plan or not. Some G-LC stocks which become bigger and have stable revenue and income might have easier access to loans, which can decrease dilution risk.
• CF-LC stock (Great cash flow with Low competition)
A CF-LC stock doesn’t need much money for inventories, new equipment or R&D budget. Many famous and mature companies in America are in this group, for instance, Coca-Cola (KO) and Wal-Mart (WMT). A CF-LC stock usually has a high payout ratio or continuously buys back its shares, so the best strategy for investing in this group is to buy when a company has a temporary problem or when the stock market has a big decline and brings down the stock to a low P/E ratio. Most ex-great stocks, when the growth stage has passed, become CF-LC stocks which are still interesting for investors who love sustainable dividends.
• Great stock
This is a great company with all 3 qualities. It can grow continuously, sustain a high margin by getting bigger and creating durable competitive advantages through its distribution network, brand recognition and economies of scale while still being able to pay a dividend or buy-back a lot of its shares, which makes EPS growth even higher. When a great company sees a big opportunity in the market, it might not pay any dividend and use more cash to capture as much market share as possible to hinder new competitors and we might see huge growth in this situation, say more than 50% a year. Some great companies that have a lot of excess cash might eliminate potential competitors by taking them over and consolidating their position in the industry. A great company run by an exceptional management which always thinks about maximizing shareholder’s wealth will have a very high ROE. Investing in this kind of stock has proven to be the fastest way for investors to become successful, just like Warren Buffett.
Conclusion
Good investing isn’t only selecting a good stock but also buying it at a reasonable price. In my opinion, the 3 groups of good stocks (G-CF, G-LC and CF-LC) should be priced around a 10-20 P/E depending on their fundamentals. Great stocks are very hard to find, especially with low P/E ratios. We usually see them when they become very well known and have a very high P/E ratio. The best strategy to invest in a great stock is following many good stocks in order to have a chance to see one that gains some attributes which enable it to become a great stock and then buy a lot of it while it’s still cheap and is still not recognized by many investors. A great stock should be priced at least around a P/E of 30. Some might even be worth very high P/E’s, around 50-70, if their 3 qualities are very strong.
When analyzing stocks, my SSD might help you to do your work easier. I’ve used it myself and it is easy to remember.
“Large future growth,
Great cash flow,
Low competition”
In Search of Great Stocks, Part II
In Part I of this series, I categorized good stocks into 4 separate groups which were G-CF, G-LC, CF-LC and Great stocks as shown in the Diagram. In this article, let’s have a look at some examples of stocks in each group through their cash flow statements so investors can gain a clearer understanding. Annual cash flow statements from Google finance are a good tool for preliminary analysis.
These examples are just a rough analysis and as I haven't thoroughly examined their fundamentals, I might underestimate or overestimate their potential.
China Education Alliance, Inc. is an education service company that provides on-line education and on-site training in the People’s Republic of China. The Company’s principal business is the distribution of educational resources through the Internet.
CEU has had extraordinary growth for the past 4 years. It operates in the online education industry, which is expected to grow for many years. CEU doesn’t need a lot of money for working capital because there are very low inventories in the online education business. CEU gets money from customers before even realizing revenue due to the fact that it sells its products and services in pre-paid card form. Moreover, it doesn’t have to spend a lot in capital expenditure (Capex) for expanding its online business. We can see in the cash flow statement that CEU has spent only $7.85m in Capex which is just 20% of the $39m cash flow from operations (CFFO) for the past 4 years. All of these contribute to great cash flow for CEU. A drawback of CEU is its low barrier to entry. There are a lot of companies in the industry which might cause even more competition in the future. I put CEU into the G-CF group for now. If it grows bigger and establishes distribution power, competitive cost or other advantages, it will become one of the Great stocks in the future.
CNinsure Inc. (CNinsure) is an independent insurance intermediary company operating in China. The Company had 48,693 sales professionals, 1,421 claims adjustors and 571 sales and service outlets operating in 23 provinces as of April 15, 2010. As an insurance intermediary company, it does not assume underwriting risks.
The insurance business in China has already been in a high growth stage and is expected to grow more in the future due to the rise of the middle income population. In the past, CISG has performed very well in terms of net income growth. It doesn’t have to invest much in working capital and it needs just a small investment, 25% of CFFO, for Capex (office space and office supplies) in order to grow. Even though CISG has great cash flow and large future growth, it operates in an intermediary insurance segment which is not difficult for new players to enter. The intense competition might lower its high 50% gross margin in the future. CISG qualifies for the G-CF group but it has to prove itself in order to become a Great stock.
China Integrated Energy, Inc., formerly China Bio Energy Holding Group Co., Ltd., is an integrated energy company in China engaged in three business segments: the wholesale distribution of finished oil and heavy oil products, the production and sale of biodiesel and the operation of retail gas stations.
CBEH’s 4-year performance looks good with very high growth. It’s expected to grow along with China’s economy but it has to invest a lot in working capital. As we can see for the past 4 years changes in working capital were very high compared to net income. This is because the nature of distribution businesses require large investments in a lot of inventories and accounts receivable. CBEH has 3 businesses ranging from production of biodiesel to retail gas stations which cover a long supply chain. This gives the company an advantage over other players which might help define CBEH as a G-LC stock. However, because of its lack of strong positive cash flow, I would rather stay away from it and any other negative cash flow companies, especially with the many rumors about Chinese stocks still flying around. As a case study, I advise investors to look at “Issuance (Retirement) of stock” in Cash from Financing Activities. Most of CBEH’s cash comes from this item as we can see that the company issues new shares every year. This is a good example of a bad cash flow company that grows very fast.
Gulf Resources, Inc. (Gulf Resources) manufactures and trades bromine and crude salt, and manufactures and sells chemical products used in oil and gas field exploration, oil and gas distribution, oil field drilling, wastewater processing, papermaking chemical agents and inorganic chemicals.
GFRE has bromine resources which are a scarce resource in China since the government has stopped issuing new exploration licenses. This makes a barrier to entry for competitors and helps GFRE enjoy high growth and high margins. However, the industry is a capital intensive industry, which causes GFRE to have very high capital expenditures that drain most of its CFFO for the past 4 years. Low competition and high growth qualities make GFRE a G-LC stock for now.
The bad thing about this kind of stock is we should expect low dividends or none at all during a growth stage. Investors should always be prepared for dilution, if the management trend is to be aggressive on their future plans.
The Coca-Cola Company is the owner and marketer of nonalcoholic beverage brands. It also manufactures, distributes and markets concentrates and syrups used to produce nonalcoholic beverages.
Coca-Cola is one of the most famous brands in the world. It has a very high market share all over the world so it’s very difficult for others to compete. It is therefore also very difficult for KO to gain more market share, this makes KO a mature company. However, KO needs only a low level of working capital and also low Capex. So the company has a lot of excess cash to pay dividends almost 50% of CFFO and has been repurchasing its shares, which is a good thing for investors holding the CF-LC stock.
Wal-Mart Stores, Inc. (Walmart) operates retail stores. The Company operates in three business segments: Walmart U.S., International and Sam’s Club. During the fiscal year ended January 31, 2010 (fiscal 2010), The Walmart U.S. segment accounted for 63.8% of its net sales, and operated retail stores in different formats in the United States, as well as Walmart’s online retail operations, walmart.com.
Wal-Mart is a top-notch retail company in America. WMT is a great cash flow stock due to the nature of the retail business where the retailer gets cash from customers first and pays suppliers later. We can see that the net working capital was positive for all 4 years and WMT spent around 50% of CFFO to invest in Capex. Remaining cash was given back to shareholders in terms of cash dividends and stock repurchases.
KO and WMT used to be Great stocks for a very long time. These two companies are good examples of Great stocks that grow for a long time, become a mature business and still have 2 qualities to be good stocks that are always worth investing in.
More thoughts on Great stocks and CF-LC stocks.
Most of the stocks in Warren Buffett’s portfolio are Great stocks or CF-LC stocks that used to be Great stocks. Buffett loves great cash flow companies that have little competition. (In his words it might be called Durable Competitive Advantage, DCA). He doesn’t care whether the company has growth or not because he can use its excess cash or dividends to buy other Great or CF-LC stocks and make growth for himself. So, if you can’t find any high growth stocks but can find many CF-LC stocks at reasonable prices, you will be able to create virtual growth by buying many CF-LC stocks as a portfolio and then use the dividends to reinvest again and again.
More to come…
In the next article I will give 3 examples of Great stocks, analyze what they look like, and show the potential of Great stocks that are deserving of very high P/E ratios.
In my earlier articles, Part I and Part II, I’ve written about how to select good companies to invest in and examples of 3 groups of good stocks. In this article, I’m going to write about examples of great stocks so that investors can understand how to use my Stock Selection Diagram more effectively.
Ctrip.com International Ltd. (CTRP) is a travel service provider for hotel accommodations, airline tickets and packaged tours in China. It also sells packaged tours that include transportation and accommodations, as well as guided tours in some instances. The Company aggregates information on hotels and flights and enable its customers to make hotel and flight bookings.
CTRP is in the online travel business in China which is a fast-growing industry and expected to continue to grow along with the Chinese economy in the future. The rise in the number of internet users in China is also an important factor that accelerates growth for CTRP. CTRP’s 4-year performance has shown a robust growth of net income at 40% per year. It is in the online business so it doesn’t have to invest a lot in inventory. Furthermore, it gets cash from customers before it has to pay its suppliers which results in long-term positive working capital. It has spent RMB 125-178m in Capex which is very small compared to the RMB 340-1027 CFOA (Cash from operating activities). From Alexa.com, CTRP is ranked 786th in world traffic and ranked 124th in China. This demonstrates that its website is well-known due to the fact that CTRP has become a big player in the industry. CTRP is getting bigger and gaining more bargaining power therefore it can get cheaper prices from its suppliers, hotels and airlines, which will make CTRP more cost competitive and make it even stronger. All of these, highly recognized brand, strong distribution network and cost leadership, render the company an invincible player in the industry. CTRP can easily be considered a great stock. It spent in Capex just 25% of CFOA (34% of net income) in order to grow around 25-30% for the next 3 years. This leaves a huge free cash flow of 66% of net income which we might be able to expect the company to pay in terms of dividends or stock repurchases in the future. CTRP’s valuation Analysts have forecasted that CTRP will have EPS of $0.90, $1.24 and $1.56 in 2010-2012, respectively, which is around 30% growth per year. At $47.52 per share, the P/E ratio is at 53 times and the PEG is 1.76 times for the 2010 fiscal year.
Baidu, Inc. (BIDU) is a Chinese-language Internet search provider. Baidu offers a Chinese-language search platform on its Website baidu.com. It provides Chinese-language Internet search services to enable users to find relevant information online, including Web pages, news, images and multimedia files, through links provided on its Websites.
Baidu.com is the number 1 search engine in China. From Alexa.com, it is ranked 6th in world traffic and ranked 1st in China. Baidu’s revenues mostly come from online advertising, just like Google (GOOG). Most of the Chinese use it every time when they want to find something on the internet. Its competitive position in China is very strong, even Google can’t compete with it. Furthermore, Its competitors are much smaller while Google’s competitors, Microsoft (MSFT) and Yahoo (YHOO), are neck and neck in many countries. There is no doubt that there will be no one who can compete with Baidu in the near future. BIDU has had extraordinary growth for the past 4 years. Net income growth was 100% in 2007, 67% in 2008 and 42% in 2009. It has huge potential to grow in the future because of the fast increasing number of internet and smart phone users. Low cost of advertising on the internet compared to other media is also an important factor that drives the industry. There is plenty of room for BIDU to grow much bigger. Speaking of cash flow, Baidu has very strong cash flow statements. It doesn’t have to invest in inventory and has very low accounts receivable. These result in positive changes in working capital every year. BIDU can grow 35-50% annually while using only around 30% of CFOA. With no comparable competitor, and ample room for growth with great cash flow, BIDU can be considered a Great stock without any doubt. BIDU’s valuation Analysts have forecasted that BIDU’s EPS will be $0.97, $1.44 and $2.27 in 2009-2011, respectively. This represents around 50% annual growth. At $109 a share, BIDU’s P/E ratio is 76 times for the 2010 fiscal year and the PEG is 1.51.
China-Biotics, Inc. (CHBT) is engaged in the research, development, production, marketing, and distribution of probiotics products, which are products that contain live microbial food supplements. The Company manufactures and sells several health supplements under the Shining brand in China. All of these products have been approved by the Ministry of Health in China. In February 2010, China-Biotics, Inc. commenced production at its facility in Qingpu and began producing bulk additives products, which are sold to institutional customers, such as dairy manufacturers, animal feed manufacturers, pharmaceutical companies, and food companies.
There are non-cash items from changes in fair value of derivatives that have to be excluded to see the real net income. I’ve adjusted them in the table below.
Up until now, Chinese dairy manufacturers imported probiotics mostly from Europe and Japan. CHBT entered into the bulk additives probiotics industry over a year ago and just started production at its new plant in Qingpu. It is now the biggest domestic player in China.
The quality of its products is equal to or better than that of its foreign competitors while prices are 20-30% lower. Entry into the industry is very difficult because the standard of food production is so high; it requires high technology; and it is hard to get licenses from the government. CHBT’s being a cost leader also gives it an advantage in terms of competitiveness.
The probiotics industry has been growing exponentially due to very high growth of yogurt and animal feed products. The probiotics consumption is predicted to grow from 3,400 tons in 2006, to 10,000 tons in 2010. (Source: Domestic Probiotics Market Analysis and Forecast Report by Beijing Leadership Management Consulting Co. Limited.)
Another source from Euromonitor has shown that, in 2009, China finally overtook Japan as the heaviest consumer of probiotic cultures, reaching over 10,000 tons (Actual consumption number reaches 10,000 tons faster than Beijing Leadership Management Consulting Co. Limited has predicted.) Euromonitor International predicts that by 2014 this will have risen to almost 18,000 tons, accounting for nearly 30% of global consumption. (Source: Euromonitor).
CHBT’s net income growth is very high and stable. Net income growth has averaged 37% annually for the past 4 years, mainly from it supplement products. For the new market segment, bulk additives, CHBT has the largest capacity in China at 300 tons a year which represents a market share of only 2.xx% in 2010. When CHBT runs its 300-ton plant at full capacity in the next 4-5 years, it will have a market share of only 1.xx% of 18,000 tones in 2014. This means there is a lot of room for CHBT to grow very fast.
CHBT doesn’t have to invest much in working capital as we can see that overall CFOA is a little higher than net income (excluding changes in fair value of derivatives.) Moreover, the probiotics industry is not a capital intensive business, so CHBT has invested around 50% of CFOA over the past 4 years in order to grow net income at least 50% annually for the next 4-5 years.
CHBT’s valuation
My forecast is that CHBT’s EPS will be $1.92, $3.33 and $5.23, during 2010-2012, which is 65% annual growth for the next 3 years. At $13.61, the P/E ratio is 7.1 times and the PEG is very low at 0.11. In my opinion, this is a great opportunity to buy a great stock at a very low price.
Great stocks usually have very high P/E ratios. In my opinion, they should be priced at least at a 30 P/E and some might be worth more than 50, depending on their fundamentals. So, to be successful in investing in great stocks, you need to buy them before others realize their potential or when there is a temporary problem which brings the price down to a cheap level.
CHBT is one great stock that is unknown to many investors. Additionally, it is having a temporary problem, which I have written about in myprevious article, so we can buy it at a very low-price. I will give more details on CHBT in my next article.
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