The Law of the Stock Market

1. Market movements
Market moves in a way that is identical to sea waves. There are always turns after consecutive movements toward one direction. There are small waves within bigger waves. Occasionally there will be extended long waves or tripped short waves.

2. Business cycles
The force against business cycle is structural changes. Institutional intervention may influence the timing of the business cycle but only significant structural changes can change the business cycle.

3. News & market trends
Good news has more positive impacts in cyclical up trend than in cyclical downtrend. Bad news has more negative impacts in cyclical down trend than in cyclical uptrend.

4. Irrationality, the investors' collective behaviour
Both sides, up & down, always reach a peak point of impossibility, e.g. "it cannot be that high" but it does, "it cannot be that low" but it does, "the market goes mad", etc. Remember, due to greed and fear factors, market always overshoots in a business cycle induced run or slump.

Stock investing and trade winds

In stock market, investors ride on waves.

Sixteen century’s sailors sailed on trade winds and currents. When the monsoon left, the sailors would stop at the harbour waiting for the trade wind of next season to travel. They did not fight inch by inch forward for it would be a futile effort. In quiet time, the sailors set their sails ready. When the next trade wind came, it brought them to where gold and spices were rich.

The paradigm is applicable in stock market. Stock market moves in waves form. When the market is down and sentiment is weak, we set our sails ready. Finding the right stock at a good price, we wait leisurely for the next wave. We don't fight cent by cent for trading "profit" that would probably lead to losses.

Stock picking and staying power are still two of the keys…

Prices of most good stocks take tides to move up. However, their prices will stay at the new higher ranges when the tides reverse. So, even if trade wind is fickle, good stocks will find harbour to stay when the wind reverse its direction. Off course, there are always exceptions in every general rule. Selecting the right stock with a good business can be like riding on a speed boat against trade wind toward your destination. Even when the general stock market waves move against you, you ride to fortune.

In the experience of Peter Lynch or Warren Buffett, it seems good stocks in US can flow against general market movement. But in Malaysia, good stocks move with the improvement of market sentiment. Such stocks would usually remain at the new higher price range even when the market reversed.

Therefore, Philip A. Fisher was right, it is about finding a fundamental strong stock with good business. Though, be patient, reward will only come when the market sentiment improved. His quote on Shakespeare is simply contagious, "There is a tide in the affairs of men which, taken at the flood, leads on to fortune."

Consistent and accurate market timing

Consistent accurate market timing is a myth.

This page is here to illustrate a point, there is no such thing as consistent accurate market prediction. Historically it never exists and it never will.

Don't hope.

Limitation and exception

Limitation
This method of detecting profit manipulation is particularly effective for manufacturing and trading companies. It is also useful for the industries like service, infrastructure, construction, property development, information technology, mining, etc. Understanding of the principles behind the practice is useful in applying the method.

However, it may rule out most construction or property development companies as badly managed due to the industries' huge stock piles and uncollectible debts. (It is also a good reason for us not to invest in the companies of such industries.) For infrastructure companies, we have to accept its high gearing ratio as reasonable since the income is contractual.

It is not applicable for financial services companies like banks, stockbroking, insurance, etc. While the principles of managing company are the same, they are reflected differently in the Balance Sheet. There are more rooms for such companies to manipulate their profit without reflecting such manipulation in the Balance Sheet. For instance, how do you know their marketable securities are valued correctly (market price for illiquid stock are not indicative as real disposable value), how can we be sure that they have declared or provided for non-performing loans, how can we be sure within the reporting period they wasn'’t any off balance sheet items took place, how much is the company's foreign exchange risks, etc). The transactions in financial services companies are much more complicated than the companies in other industries.

Historical performance is the key to understand their real performance other than merely checking their Balance Sheet'’s movements. For instance, growth story behind a dismal historical performance is unreliable.

Exception
Enron is an odd case. It will escape our attempt to detect profit manipulation, simply because it didn'’t consolidate the results of all the companies within the Group. Enron created certain corporate structure that, under U.S. accounting standards, allowed it not to consolidate these loss making companies into the Group accounts. Luckily such loop hole is only available in United States. Malaysia adopts International Accounting Standards, a principle-based Standards just like U.K., Singapore, Hong Kong, etc.

Enron used off balance items in constructing their profitability. To overcome such deception, we must look at the Notes to the Accounts for such off balance sheet items like corporate guarantees, capital commitments, contracts, options written, etc.


Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation - Concluding Steps

The question to be answered for the entire 5-step-exercise is that "Does the profit generate real cash?"
If the entire profit is almost equal to the net movement of S+TD-TC, the answer is NO. In such a case, the company is either
a. Operationally badly managed
b. Manipulating profit numbers, or
c. In the phase of growth

We cannot differentiate a. and b., but it doesn't matter. Both reasons are good enough for us to avoid investing in such company. Other steps provide us information how the company uses its profit.

The checking begins with Step 2 - movement of cash and bank balances. What if the Cash and Bank Balance is faked?

Faking profit through cash and bank balance is the last thing that accountant or management wants to do. It leaves trail in bank reconciliation or cheques books. In corporate world, the best lie is the lie that can be justified professionally due to subjectivity. For instance, there are various methods for stock valuation that lead to different numbers; performing and non-performing loans can be subjective; timing of billing can be arguable, particularly for construction and IT companies; vendors can be blamed for late billings and that accrual was not done due to staff omissions. These are the grey (and safe) areas that accountant and management want to exploit.

Only in a desperate situation, where all means of profit manipulation were exploited, the management will take the risk of creating fake cash for profit. In such a case, Step 3 would have revealed such badly managed company. We would have avoided investing in it right at the beginning.

Nobody wants their company to be badly managed, including those who manage it. It depends on the management integrity in reporting the truth. However, if the management chooses the evil path of deceiving, the first step of evil path (or selling soul) is always the easiest (or the seemingly harmless) step, i.e. S+TD-TC. (Step 3)

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation – Step 5

Step 5 - Other creditors and debtors

If ultimately the movements in Balance Sheet that match the funds from profit are the movements in other creditors and other debtors, we must know the reasons of such movements. Such information is usually not available in quarterly report and sometimes not even available in annual report.

The way to deal with such movements is to wait for next quarter’s Balance Sheet. Such increase in other debtors or other creditors should be of temporary. It should be alarming if the amount keep increasing in Balance Sheet for two quarters.

It can be due to something as simple as payment or repayment of rental deposits, down payments of agreement, etc. Therefore it should be either of something one off or short term.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation - Step 4

Step 4 Capital expenditure, goodwill, tax payment and dividend

Sometimes, despite showing net profit, there is no significant change in net cash/debts and/or S+TD-TC. We must then look elsewhere to find out where were the funds gone (for real profit) or where were the profits juggled from (for fake profit).

The items listed below are usually NOT “alarming” items in detection of profit manipulation. There are more of “assuring” items on providing us a full understanding of where had the money gone. The judgments on “whether those are good management decisions” are business calls.


Capital expenditure

Movement of fixed assets shows capital expenditure.

Fixed assets as at current period end = Fixed assets as at preceding period end + capital expenditure - depreciation

Company may acquire fixed assets like plants and machineries, vehicles, lands, office equipments, computers, etc. Accountants may hide losses by charging repair and maintenance expenses to fixed assets as capital expenditure. However, as fixed assets are important items for taxation, they are subjected to careful scrutiny by auditors and tax agents. Accountants will usually avoid using fixed assets as a way to manipulate profit.

For the purpose of detecting profit manipulation, there is nothing alarming should the funds from profit were used for capital expenditure. Whether such capital expenditure is good or acceptable to the investors is the matter of business judgment.


Goodwill

Goodwill increases when the company acquires subsidiaries with a price more than the subsidiaries’ book value.


Tax payment

The increase of tax recoverable or reduction in tax provision in Balance Sheet is, sometimes, due to cash payment to IRD. However, we should double check income statement’s taxation row (below profit before tax, above profit after tax).

Sometimes the accountant may decide to reverse tax provided which would jacked up profit after tax. Do a quick check by dividing tax over profit before tax. A range between 20% and 35% is acceptable depending on industry.


Dividend payment

Dividend payment would reduce net cash or increase net debt.

Retained profit as at current period end = Retained profit as at preceding period end + profit – net dividend

At this point, most likely you have got a rough picture on whether the profit generates cash or on how the company utilized its profit.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Basic understanding of inventories, trade debtors and trade creditors

When the profit is not reflected as positive net cash or net debt movement, the natural places to look for the profit are trade debtors and inventories/stocks.

Stocks, trade debtors and trade creditors are the natural path of business process.

When vendors deliver stocks or raw material, trade creditors and stocks increase. When a sales is made, stock reduce, trade debtors increase. When the company pays its vendors, trade creditors reduce. When the clients pay, trade debtors reduce.

When stock is obsolete, stock amount in Balance Sheet will increase. When clients refuse to pay, trade debtors increase. While the company still need to pay its trade creditors.

Essentially, trade debtors, stocks and trade creditors reflect business process in financial terms.

So it is BAD SIGN when stock and trade debtors increase. There is only ONE exception that should be tolerated by investors, with very strict conditions. We will deal with it later.

There are three reasons why S+TD-TC increase,

• Bad operation, i.e. bad collection period, bad stock management, bad purchasing process, etc.
• Profit manipulation, i.e. reversing previously provided provision for obsolete stocks or bad and doubtful debts, not making provision for uncollectible debts, not making provision for
• Revenue growth

First and second items are bad. Third item MAY BE good, if the revenue growth exceeds the S+TD-TC's growth, proportionately. We, thus, need to do further calculation.

Calculate Net S+TD-TC turnover days:
S+TD-TC / Revenue (Turnover) per annum x 365, OR
S+TD-TC / Revenue (Turnover) per quarter x 92

Compare the number of current period with preceding period and previous year corresponding period. If current period’s S+TD-TC turnover increase (deteriorate/ slower/ lower) it reflects deterioration of operation efficiency or profit manipulation.

We can then further analyze the turnover days of each item, i.e. inventories/ stocks, trade debtors & trade creditors, separately.

Back to Step 3: inventories/stocks, trade debtors and trade creditors.

Detecting profit manipulation - Step 3

Step 3: Inventories, trade debtors and trade creditors movements

First test:

If trade debtors amount in Balance Sheet is bulky, with collection period exceeding three months, drop every analysis. Save your breath for a better company.

It is the same for inventories/ stocks. If stocks amount in Balance Sheet is bulky, with stocks turnover period exceeding three months, drop every analysis. Save your breath for a better company.

Generally, a company with long collections period and inventories turnover is either operationally badly managed or having problem in generating sales. Either way, we should not waste our time and money to invest in such company.


Second test:

First, let’s calculate the net total of Stocks Add Trade Debtors Less Trade Creditors (S+TD-TC). Second, we calculate the movement of S+TD-TC of two Balance Sheets period.

If S+TD-TC movement increases, we have to worry. If S+TD-TC movement decreases, we are relief. If the increase of S+TD-TC is almost the same as Net Profit add Depreciation, we are quite sure that the company has not made a single sen of real profit yet. There is no hard cash from the profit.

However, if the revenue increase proportionately, not less, such increase in S+TD-TC is acceptable. Should S+TD-TC increases for two quarters or more without the proportionate increase in revenue, dump the shares.

This is all about Step 3. A company that does not pass the screening test is either badly managed or manipulating their numbers. We cannot differentiate the two, but either way we should not invest in such company.

Click here for further explanations.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Understanding trade debtors and stocks

The net amount of "Stocks Add Trade Debtors Less Trade Creditors" (S+TD-TC) reflects business operational efficiency. A well managed company ALWAYS has slim "S+TD-TC"”, which is the reflection of an efficient business operation.

Trade debtors amount, in the Balance Sheet, is SLIM if the collection period is less than two months. Three months period is considered bulky and barely acceptable. For a collection period more than three months, the management is having problem in collecting debts. Investors, run!

Collection period formula:
Trade debtors / Sales (Turnover) per annum x 365, OR
Trade debtors / Sales (Turnover) per quarter x 92

This is the same for stocks. Stocks amount is SLIM if the stock turnover period is within two months. Three months period is considered bulky, low, slow and barely acceptable. For a stock turnover period more than three months, the company is having obsolete stocks that nobody wants, having a big problem in production flow and/or having a bad purchasing process.

Stock turnover period formula:
Stocks / Cost of sales per annum x 365, OR
Stocks / Cost of sales per quarter x 92
* Sometimes there is no data on cost of sales. The alternative is estimated cost of sales = Sales (turnover) x (100% - profit margin%)
The longer the period, the slower or lower the stock turnover and the higher chances of obsolete stocks, bad stock management or bad production flow.

Accounting text books make no effort in differentiating stocks and trade debtors from cash in measuring liquidity. Therefore, when we were students we couldn't figure out whether bulky current assets is good or bad. Now the answer is clear: Bulky Stocks and Trade Debtors are BAD for business. Bulky cash has no harm.

Illustration 1

Consider this fact:
1. Debtors collection period = 3 months
2. Stocks turnover period = 3 months
3. Creditors payment period = 3 months

Observations:
This company managed to get their creditors to finance their stocks. However, the company still needs to finance its trade debtors equivalent to 3 months of sales.

Illustration 2

Consider this fact:
1. Debtors collection period = 0.5 month
2. Stocks turnover period = 1 month
3. Creditors payment period = 3 months

Observations:
This company managed to get their creditors to finance their stocks and debtors. It is reflected in their Balance Sheet that the company doesn't have to spend a single penny in operation. Good business.

AEON Co. (M) Bhd (Jaya Jusco) is the perfect example of Illustration 2. On their supermarket retail business, AEON has no debtors (cash business), high stock turnover (less than one month) and get their suppliers (Creditors/ Payables in Balance Sheet) to give 3 months payments period. The suppliers is financing AEON's stocks, debtors, cash and part of their capital expenditure. Check out their balance sheet here, AEON has negative S+TD-TC. This kind of business, that let the creditors to fund its operation, is the extreme of the above example. But the idea should be illustrated well.

By refusing to provide and charge out obsolete stocks and/or bad and doubtful debts to income statements as expenses, the management is manipulating profit. Naturally the Balance Sheet looks bulky.

The worst case scenario is that the management decides to reverse previously provided provisions, therefore increase the stocks and/or debtors amount in the Balance Sheet and create fake profit. This shall reflect as a big positive movement in S+TD-TC.

In a nutshell, bulky S+TD-TC is BAD and slim S+TD-TC is GOOD. Positive movement (increase) in S+TD-TC is BAD. Negative movement (decrease) in S+TD-TC is GOOD.

The exception is revenue growth. Even in such a case, debt collection period and stock turnover period should not deteriorate.

Back to Step 3: inventories/stocks, trade debtors and trade creditors.

Detecting profit manipulation - Step 2

Step 2: Net cash/ debts movement

The first question to answer is, “Does the profit bring in real cash?”

In order to know whether there is improvement in a company’s financial position, it is useless to look at cash and bank balances only. We must see the NET of Cash, Bank Balances and TOTAL Borrowings, in order to know whether the profits bring in real cash.

Calculate the change of net cash/(debts) between two Balance Sheet dates. We need to know the movement of net cash/(debts).

Net Cash/(Debts) = Total Cash & Bank Balances – Short Term Borrowings – Long Term Borrowings. The company is EITHER in a net cash position OR net debt position. We calculate the movement of net cash OR net debt.

Get the movement amount out and compare it with Step 1’s Net Profit Add Depreciation. We also need to find out more of other movements in Balance Sheet to know the whole picture.

This is all for Step 2.

Positive movement, i.e. increase of net cash or reduction of net debt, that match Net Profit Add Depreciation indicates possibility of true profit, though we cannot conclude it before looking at other movements in the Balance Sheet.

We have to worry about negative movement. What makes a profitable company to have deteriorating cash or financing position? It can be due to capital expenditure, it can be due to dividend and/or tax payments. It can be due to deterioration of operating efficiency or profit manipulation that cook up the stock and debtors level. We will need to find out.

Cash flow statement is not very helpful in detecting accounting manipulation because it split out the changes in cash and bank balances from the changes in borrowings.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation - Step 1

Step 1: Net profit and depreciation

You need to know two numbers:
a. profit after tax (before minority interest, if any)
b. depreciation

That’s all for Step 1.

Problems you might encounter:

The quarterly report format approved by Malaysian Accounting Standards Board (“MASB”) took a step backward that the disclosure of depreciation can be avoided. MASB allows CONDENSED Cash Flow Statement that can hide many important breakdowns. It is frustrating considering the importance of depreciation to estimate owner’s earning (as per Warren Buffett’s methodology) and to understand cash flow. However, most decent companies still disclose depreciation voluntarily in their quarterly report announced to Bursa Malaysia.

If the depreciation number is not available in the quarter report, you can estimate the number from their previous financial year annual report. It should not run too far under normal circumstances.

Skip this part if you are familiar with financial reports. For novice only:

If you are reading annual report, the comparing balance sheets are that of the current year end and preceding year end. The profit and depreciation figures are of the current year.

If you are reading quarterly report to find out quarterly performance, the comparing balance sheets are that of the current quarter end and preceding quarter end. The profit and depreciation figures are of the current quarter.

If you are reading quarterly report to find out year-to-date (for instance, three quarters) performance, the comparing balance sheets are that of the quarter end and preceding year end. The profit and depreciation figures are of the year-to-date ended at current quarter end.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation - overview

Authentic profits generate hard cash. Manipulated profits stick in other assets like stocks, debtors, reduced creditors and provisions, etc. To detect profit manipulation we need to find out where these funds (from profit) are reflected in the Balance Sheet.

The rightful places in Balance Sheet for funds (generated from profits) are:

• increased cash and bank balance
• reduced borrowings
• additional fixed assets
• reduced retained profit (due to dividend payments)
• reduced tax provisions or increased tax recoverable (due to tax payments)

The 'wrongful' places for such funds (generated from profits) in Balance Sheet are:

• increased stocks
• increased debtors
• reduced trade creditors
• reduced provisions (due to reversal)

The actual method of detection will be addressed in the Part 4's step-by-step guide.

Balance sheet and cash flow statement are not arranged in the way to facilitate the checking profit authenticity.

(Even as an Accountant I do wonder what on earth these Standards Board members are thinking when they set the format of presentation. The financial presentations required by the Accounting Standard look nice, consistent and comprehensive, though it doesn't serve any purpose for decision making.)

We need to do a slight rearrangement of balance sheet's numbers. The objective is to find out where the funds (generated from profits) are landed or reflected in Balance Sheet. We shall get our hands dirty in the coming step-by-step guide.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

The principle of profit manipulation

Profit manipulation comes in many faces. However, generically or technically there is only one way to do so:

To jack up profit, an accountant must CREDIT (CR) the accounts in Profit and Loss accounts. The beauty of accounting is that inevitably he has no choice but DEBIT (DR) the accounts in Balance Sheet.

Dr Balance Sheet
(Increase assets like stocks, trade debtors, etc. or reduce liabilities like trade creditors, provisions, etc.)

Cr Profit and Loss accounts
(Increase revenue or reduce costs)

The above double entry is the mother of all profit manipulation. There are rare exceptions and we will address them later.

Backed by the above core double entry, these are the common masks of profit manipulation:

• Reduce cost of sales by increase the value of closing stock
• Refuse to provide for uncollectible bad and doubtful debts
• Reverse previously provided provisions for bad and doubtful debts without true sign of debts recovery
• Delaying in charging out expenses
• No accrual was made for known and quantifiable expenses
• Fake cash (less common, more difficult to perform and subject to higher risk of being prosecuted as criminal.)
• Etc.

The way to detect profit manipulation or to ensure the authenticity of profit is first to look at the movement of Balance Sheet! In the case of jacking up profit, beside the increase in retained profit, Balance Sheet will also reflect a significant increase in assets or reduction in liabilities.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Reading financial statements

Knowledge is power. This is particularly true when it comes to investing. Knowing a company's business performance and its industry well enough enables us to buy or sell its stocks confidently and correctly. Knowledge and information improves quality of our investing decisions.

We can gain such knowledge and information of a company predominantly from their financial statements. When we look for a company with strong management, solid financial positions, earning growth, etc. look no further but the company's report card: its financial statements. Searching for a proper valuation of the stock? Let's begin with the financial statements. Analysts from the entire stock investing/ trading profession analyze and comment on the financial statements of listed companies every quarter. Great investors like Benjamin Graham, Warren Buffett, Philip A. Fisher, etc. read financial statements before further facts finding. In fact, all investing fundamentalists read financial statements.

It is suicidal to practice investing characteristics like "being patient", "being quick to response", etc. without the backing of knowledge and information. It is knowledge and information that provide great investors their unweaved beliefs in their decisions, whether it is being patient or being quick to cut loss.

With knowledge and information, we are able to be patient and to hold on to jewels like Wells Fargo, Walmart, Public Bank, OYL, etc. that can (and had) brought fortune to the stockholders. Without knowledge and information, we psyche ourselves up to "be patient" on Enron, Bestcorp, Omega, etc. and to see our life savings evaporated when these companies failed. Both are being patient, the difference lies in what we know about our investments. It comes from reading the financial statements.

(So don't advice other to BE PATIENT or BE DECISIVE in holding on or disposing their investments. Such advice can only come after knowing the true financial performance and status of a stock. BE PATIENT and BE DECISIVE are dirty investing words without the backing of knowledge and information of a particular company.)

But why, in general, layman investors don't read financial statements? One of the main reasons I suspect is that layman investors basically throw in the towel in believing that performance of stock prices has got anything to do with the company’s financial numbers. Reading financial statements is, sometime, a futile effort in knowing the company performance. Profit numbers are unreliable. They are right. Looking back at 1997 Asia financial crisis and 2000 Dot Com Bubble, failed companies unabashedly manipulate their numbers before their demises. Stock prices crashed before showing any sign of losses, or before the reported profits were rediscovered as losses. The unscrupulous managements cheated in their report cards. It is reasonable for investors to believe that it is useless and meaningless to read financial statements. However, this is not true. There are ways to detect profit manipulation. We, as investors, can definitely detect profit manipulations.

We rely on the numbers provided by the management to make our investing decisions. These numbers have to be authentic and we must have confident in relying on them. To confidently relying on numbers in making investing decisions, we must be able to detect profit manipulation. Before we learn how to detect profit manipulation, we first must learn how the accountants manipulate the profit numbers.

In Part 2, you will find how accountants cook their books. In Part 3, we will learn how to detect such manipulation.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Stocks selection: Warren Buffett's criteria

In his book, The Essential Buffett, Robert G. Hagstrom listed down twelve basic principles that guide Warren Buffett investments decisions.

It can be organized in four areas:
a. Business
b. Management
c. Financial
d. Market

Warrent Buffett's twelve investment principles

On Business

1. He invests only in the businesses that are simple and understandable

Hagstrom wrote, "...he purposely limits his selections to companies that are within his area of financial and intellectual understanding..." because otherwise "...you cannot possibly interpret developments accurately or make wise decisions." and that "...the key (for a business) is to do those ordinary things exceptionally well."

An investor needs to do very few things right as long as he or she avoids big mistakes. - Warren Buffett

2. With consistent operating history

Buffett avoids purchasing companies that are either changing directions due to past failures or going through a difficult time. "...best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors."

Severe change and exceptional returns usually don't mix. - Warren Buffett

3. With favourable long-term prospects

Buffett prefers businesses with pricing power. Such pricing power usually comes from products differentiation. To Buffett, commodity businesses, (i.e. oil, gas, chemical, lumber, and even computers, automobiles, airline services, etc.) that has no meaningful product differentiations therefore lacking pricing power, are not worth purchasing.

The companies with pricing power, called "franchise" business, provide products or services that
a. is needed or desired,
b. has no close substitute, and
c. is not regulated.
(i.e. consumer products,

"This pricing flexibility...allows them to earn above average returns on invested capital."

The key question on long term prospect is therefore whether a business has pricing power through product differentiation. "A franchise can survive inept management; a commodity business cannot," Hagstrom wrote base on comments from Buffett.



On Management
(details coming soon...)
4. Is management rational
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?

On Financial

7. Focus on return on equity, not earnings per share
8. Calculate "owner earnings"
9. With high profit margins
10. Achieve more incomes (will reflect in market value) with less capital (retained profit)

On Market

11. Determine value of the business
12. Buy the business cheap

About RISK from FPM

1. True RISK is not about price changes; it is about permanent loss of investment value. We denote it Risk(t)
2. "Fake Risk" that is triggered by mere price changes can be completely eliminated through a longer investing time horizon. With a well informed investing decision and prepare to stay for a longer time zone, we can keep the return high without such "Fake Risk". This definition of risk is being used by academics and professionals. We denote it Risk(a).

("Fake Risk", at FPM, is what Buffett referring to as "academic's definition of risk--the volatility of the share price". I know by labelling such academic and professional definition of risk(a) as "Fake Risk" I can be rediculed by many. But if you able to think logically you will understand volatility does not create risk nor does it create possibility of loss, if you are able to hold a good stock for long term.)

This is one of the most important sections of the book--The Essential Buffett, by Robert G. Hagstrom.

Buffet's View of Risk
In modern portfolio theory, risk is defined by the volatility of the share price. But, through out his career, Buffett has always perceived a drop in share prices as opportunity to make additional money. In his mind, then, a dip in price actually reduces risk. He points out, "For owners of a business--and that's the way we think of shareholders--the academics' definition of risk is far off the mark, so much so that it produces absurdities." (Berkshire Hathaway Annual Report, 1993, p.13)

Buffet has a different definition of risk: the possibility of harm or injury (in other words, permanent loss in the value of investment). And that is a factor of the "intrinsic value risk" of the business, not the price behavior of the stock. ...harm or injury comes from misjudging the future profits of the business, plus the uncontrollable, unpredictable effect of taxes and inflation.

Furthermore, risk, for Buffett, is inextricably linked to an investor's time horizon. If you buy a stock today, he explains, with the intention of selling it tomorrow, then you have entered into a risky transaction. ...But in Buffett's way of thinking, buying Coca-Cola this morning and holding it for ten years puts the risk at zero.

These two points are the basis of FPM's investing philosophy. When we assessing the risks of investment, remember to differentiate true risk, risk(t), from fake risk, risk(a).

Stocks selection: Fool's criteria

Ok, this is from Motley Fool.

Their 7 simple triats in selecting stocks.

"...
1. Capitalized under $2 billion
2. Extremely well managed
3. Run by executives that own loads of stock
4. Heavy on assets, light on debt
5. Valued at less than the market average

Most importantly, every one is (6) cash flow positive and (7) operates a successful business in a profitable niche market."

Check out the full text here...

FPM's stock selection criteria

Introduction

Stock selection criteria: Sustainable dividend income with dividend returns over investment exceed 10% per annum.

Do you think this is impossible? With current maximum dividend yield is only about 7%, how do you get one that exceed 10%?

This is the stock selection criteria that base on FPM's financial planning principle.

FPM’s financial planning principle

Stock selection begins with knowing the strategies you adopt for financial planning. The heart of financial planning is to build assets that generate sustainable income.

Explanation

Many think stock is a bad example of “assets that generate income” or assets(i). Generally average dividend yields for Malaysia stocks, in a good market conditions, range below 8%. Should Malaysia’s market moves toward what U.S. is heading, dividend yield could be lower in future. The dividend would be too little as a source of income as compare to the investment, it seems.

But the key is not dividend yield (dividend over current share price); the key is dividend over your original investment cost.

You bought a stock at RM1,000 five years ago which gave net dividend yield of 6% or RM60. Today, due to real organic growth both of its earnings per share (EPS) and dividend per share doubled. Share price increased. Let’s say its net dividend yield stays at 6% (It doesn’t matter, actually). Fund managers say, “The yield is reasonably attractive.” But for you, who bought the share at RM1,000, now enjoy an annual dividend of RM120, which is annual return on investment of 12%!

When you buy a share, your investment cost is fixed. With growth, good financial policy and consistent dividend payout policy, your dividend per share would increase as time goes by. Your annual ROI, over time, increases even if the stock dividend yield remains low (if the share price goes up.)

First set of criteria: growth stock that gives or will soon give sustainable and consistent dividend payout

This lays down the first set of FPM’s stock selection criteria,
1. The business and earning per share must grow
2. It is real growth. Such EPS growth must be translated into real hard cash or reduction of net debts. (real earning growth)
3. The management is willing to pay out the earnings as dividend. Dividend will grow in tandem with earnings. So, it should lead to a better dividend pay out per share.

4. What is not:
EPS grow without real incoming cash that lead to increase of cash or reduction of borrowings. Dump those shares that show profit but with a much higher increase in Stock, Trade Debtors less Trade Creditors. (compare to sales). Such company is either suffering a temporary operational inefficiency or outright cheating in their accounting.

5. Exceptions
On dividend payout there are exceptions. We can disregard dividend payout, IF and only IF
a. we are convinced the company is going through a high growth phase that required cash.
b. In the case of Second Board’s counters, if the company need to accumulate sufficient reserves to upgrade to main board.

Other than a. and b. we shall not buy into any company that does not fit into the four criteria above.

Second set of criteria: well managed cash cow

Well managed cash cow that generating hard cash profit, employing little assets and with certainty for growth. All profits turn into cash and with high dividend payout ratio.

Conclusion

We basically disregard what the share prices are or going to be but solely focus on the growth of its business earnings, the ability to generate hard cash profit and dividend payout. We accumulate assets (stocks) that generate consistent good income (dividend) which we call it assets(i), remember?

The key, dividends grow, but your original COST of investments does not. (Business grow, value grow, share prices may or may not increase) So if you select a stock with business that grows, does well and has cash to give out consistent dividends, your income increase and your return over your investment (ROI) increases over time.

Warning. Be careful now.

If you have taken a good ride with the recent recovery of second board shares, may be it is time to be more careful. If there is anything you want to sell, do it before 30 June 2005. Or may be at the safe side do it now, before 29 June 2005.

Why?

Window dressing. All listed companies are required to announce their financial performance quarterly under the Bursa Malaysia Listing Requirements. Every fund managers, banks and stockbrokers wants better closing share prices on 30 June 2005. This will reflect lower losses or higher profits in their quarterly financial reports. It is of everyone interest to keep the prices high and the momentum going until 30 June 2005.

Considering the magnitude of this quarter’s market losses that affect many banks, fund managers and stockbrokers, most houses are desperate to show a better number. There is a possibility that the prices might fall right AFTER the end of this quarter.

I may be wrong, but just watch.

Another Four

Another four stocks hit several limit downs for the last few days.

11. Ngui Kee Corporation (M) Bhd
12. B.I.G Industries Bhd
13. Hwa Tai
14. Gadang Holdings Bhd

We know current sell down on second liners is primarily due to the pulling back of share financing lines by stockbrokers and bankers. Pressure was on lower liners. Every cut of lines or exclusion of some stocks as "marginable" stocks creates another round of limit down.

Yesterday 5 leading bankers stood out to vow continuous supports on share financing. The effect? We will have to wait and see. It is probably time to study and shop for cheap stocks. Don't throw your money all in one go. Buy in stagger over a year should be the best strategy.

Finding Financial Information

All listed companies in Bursa Malaysia (formerly known as Kuala Lumpur Stock Exchange or KLSE) are required to announce their results quarterly. You can find these quarterly reports at the company announcements section of Bursa Malaysia's web site. Click on the "Announcements" at the left panel, choose either current for recent announcements or historical for old announcements. Remember to sort the list by company.

At the very same page you may find annual reports or audited financial statements. Look at the left panel to search for the words "Annual Audited Accts" or "Annual Reports".

For company database, e.g. profile, directors, shareholders, financial data since 1997, etc., you may sign in to KLSE-RIIAM Information System. There is a wealth of free information on all the counters listed in Bursa Malaysia.

Online Stock Brokers in Malaysia

Are you looking for online stock brokers in Malaysia?

This is the list of brokers with online trading system.

• HLeBroking from Hong Leong Investment Bank.
• RHBInvest from RHB Securities Sdn Bhd
• OSK188 from OSK Securities Bhd
• e-Kenanga from Kenanga Investment Bank
• Maybank2u.com Online Stocks from Mayban Securities Sdn Bhd through its holding company Maybank Berhad
• HwangDBS-E'Invest from Hwang-DBS Securities Berhad
• TA Online from TA Securities Holdings Bhd
• Jupitor Online from Jupitar Securities Sdn Bhd
• PacOnline from Inter-Pacific Securities Sdn Bhd
• AmeSecurities from AmInvestment Bank
• SJenie trading platform by SJ Securities Sdn Bhd, powered by N2N Connect trading platform. They offer mobile app trading via iMSL@SJenie

I prefer HLeBroking and RHBInvest for their simple and straight forward layout designs. Their backgrounds? All securities firms in Malaysia (34 of them, currently) are licensed by Securities Commission established under the Securities Commission Act 1993. You can be quite sure that they are being monitored tightly by the regulators. This the full list of online stockbrokers in our financial directory.

Here is the complete list of licensed stockbrokers (participating organisations) in Malaysia.

Has the market reaches its bottom?

Has the market reaches its bottom?

Far from it, we believe. Historical trend shows that it usually took over a year or more for the market to fall from its peak to its bottom.

And this is the best time to find a good stock for dollar-cost averaging.

Market sell down

In the past three weeks there was a sell down of shares in Bursa Malaysia. Four stocks, in total, lost about RM2.0 billion of their market capitalization. There was a very interesting article on how the saga unfolded in The Edge, Malaysia. It listed down 10 companies with steep falls in their share prices since last October 2004.

On the recent melt down, it seems it was the credit providers, i.e. bankers and stockbrokers, who got hit the most. The market...more appropriately the bankers and the stockbrokers lost RM2.0 billion. Who made the gain?

These are the four companies
1. Foremost Holdings Bhd
2. Golden Plus Holdings Bhd
3. Seal Inc Bhd
4. Fountain View Developmnent Bhd (lost RM1.7 billion of its share value: RM4.80 on 27 April 2005 and 57 sen on 5 May 2005)

These are the rest
5. Fajar Baru Capital Bhd
6. Sanbumi Holdings Bhd
7. Suremax Group Bhd
8. Mahajaya Bhd
9. Lii Hen Industries Bhd
10. Liqua Health Corp Bhd

I believe there will be more counters joining the list above triggered by the credit crunches from the stockbrokers and bankers in coming weeks. Therefore THE question is: which counter's next?

The burning questions are
1. What is the common characteristics of these stocks reflected in their financial and corporate information?
2. What other stocks with such characteristics have not had their prices plunge yet? In short, who's next?