Tuesday, July 16, 2013

Short-sellers rely on fundamental analysis!

Here is a very interesting article, "Those Evil Naked Short-Sellers Actually Trade On Fundamentals, Study Says" by Daniel Fisher.

It is through fundamental analysis that we can know the financial weakness of a company before the true picture is showed in income statements.

It is really not surprising that the short-sellers target on companies detected with obvious financial weakness before markets take note of the conditions. They are "evil" only because they detect and exploit the weaknesses hidden away from public.

They are the makers of efficient markets.

It is through fundamental analysis that we can make decisions (not short-selling, but avoiding) before the market price actions.

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Company: Pharmaniaga Bhd

This is a classic example of why we need to be more careful in reading financial statements.

The numbers and indicators above paint a positive picture of recent performance of the company:
  • Healthy growth in revenue, profits and earnings per share ("EPS")
  • Growing shareholders' equity and net assets per share
  • Growing dividend per share
  • Improving profit margin since 2010

Things seem perfect.

But if you analyze its Balance Sheets, it gives you a different picture.

Pay attention to the changes in balance sheet items.

The working capital in total, i.e. inventory ADD trade debtors LESS creditors (I+D-C), increased more than RM300million or by 576% since year ended 2010!
  • Inventory turnover deteriorate from 71 days in 2010 to 102 days in 2012. The company needed to fund the inventory, in year ended 2012, twice the size of that in year ended 2010. (2012: RM465million, 2010: RM230million)
  • Net profits for financial year 2011 and 2012 are RM52.8million and RM63.2million respectively. In total, RM116.0million. The working capital I+D-C increased by RM305.2million from 31 Dec 2010 to 31 Dec 2012. This means profits did not turn into real cash but merely used to accumulate inventory.
  • The revenue growth was in the range of 10% - 20%, but the working capital (I+D-C) growth was 366.9% in 2011 and 44.8% in 2012

In fact, the company turned from net cash position of RM69.9million in year end of 2010 to net debts of RM306.5million in year end of 2012. It was a deterioration of RM376.3million!

Large borrowings in year end of 2012.
EDR of 59:41 is beyond my comfort level of 70:30 to invest in the company's shares.

With deteriorating gearing ratio and bloating inventory, it is only natural for me to have doubts like
  • Is the profit real since the company generate little cash flow from operations? 
  • Any problem with inventory valuation? or any problem in manufacturing or planning that caused a high inventory book value?
  • With such gearing and cash flow, is current dividend payout sustainable?
  • Current trend of cash usage is definitely not sustainable, when will there be a reversal of trend?

In 2013 Quarter 1 results, the inventory level did improve a little. The net borrowings position improved marginally to RM304.3 million. The overall picture in Q1 2013 stayed the same.

As investor, we have limited bullets (limited cash available for investment). We need to be selective. There may be many good reasons or exciting growth stories of why the Company's balance sheet should be like this for just a while. But it is not important, because it means uncertainty. And that there are other listed companies that give a positive, crystal clear AND consistent picture of its financial affair, available in the stock markets.

I remind myself of my investment objectives:
  • There are other listed companies that shows growth, positive cash flow and with healthy gearing. So I don't need to jump into such uncertainty of outcome investing in this company
  • I am looking for Company with business that can sustain a growing dividend to its shareholders
As such, I am looking elsewhere and not dwelling into valuation of the shares.


Sunday, July 07, 2013

Fundamental analysis and value investing: from a book review

Charles Sizemore wrote a book review on Intermarket Analysis And Investing by Michael E.S. Gayed in Forbes.

He wrote, "Gayed addresses the strengths and weaknesses of each of the major schools of investing thought. For example, of fundamental analysis he writes that it is “more reliable than any other approach…tangible and logical.” But also acknowledging its shortcomings, he notes that 'fundamentals tend to lag behind the price action. The discounting mechanism of the market often senses evolving financial problems before the company actually discloses them.'"

I think this is a common misconception of fundamental analysis. In fundamental analysis, we don't wait for company's disclosures to know its financial problem. we can sense the company's financial problems easily and ahead of others by noticing its changes in balance sheet's items like inventory, receivable, payable, gearing, etc., its cash flow and the consistency of three elements in financial reporting, i.e. financial performance, changes in balance sheets and announced stories.

What we need is a complete analysis on balance sheets and cash flow statements to smell troubles ahead.

In fact, Daniel Fisher, another writer of Forbes wrote this article, "Those Evil Naked Short-Sellers Actually Trade On Fundamentals, Study Says", stated that the short-sellers rely on fundamental analysis to trade. They detect and exploit financial weaknesses of companies. It is not beautiful, but fundamental analysis allow them to act before market price action.

Balance Sheets' Items

The health of a company's business operations reflects in the management of inventory, receivable and payable. A good company with healthy operations shows a "thin" working capital items like inventory and receivables. The balance sheet of a company with healthy inventory turnover, prompt collections of account receivables and willingness of suppliers to provide longer financing reflects a small Net Current Asset's value of "Inventory ADD Account Receivables (Debtors) LESS Account Payable (Creditors)" ("I+D-C"). Consistent increase of this "I+D-C" value reflects deterioration of management performance, e.g. mismanagement or bad planning of inventory, raw materials, and problematic production processes, longer credit period to keep unhappy customers from leaving, non-collectible sales revenue, disputed sales, lacking clout on suppliers and is forced to pay cash for inventory due to bad reputation, etc.

A balance sheet with bulky inventory, bulky receivable, and small payable indicates either a mediocre company or a troubled company with manipulated income statements. Read here.

Fundamental analysis enabled you to avoid such company. Or alert the value investor early enough to sell the stocks before market price actions.

Cash flow

Has the company been generating positive operating cash flow? Has it been paying down its borrowings? Has the gearing less than 30% of its total assets? If the answers of any of the above are NO, we need to be alarmed.

Avoid or sell the stocks of the company that does not generate operating cash flow. In some cases, I even avoid those that generate positive operating cash flow but with negative net cash flow.

Opportunities in the stocks market are unlimited but our money is limited. Sell and run, if the company you invested in was not generating positive net cash flow. We don't have to wait. Whether there will be a financial problem in the future, it is irrelevant to value investors like us.

Announced Stories

We can estimate future performance from the announced statements and notes to the financial statements. I remember one of the stocks I held:
It was a listed company. In one of its quarterly reports it explained that the profit reduced as there were many festive holidays during the quarter and that the plant had already reached its full capacity. Six months down the road, when it announced the purchase of a new plant, I immediately knew that the profit was going to increase before the commission of new plant.
I just wish to make a point that by linking the financial numbers to Notes to the Financial Statements and announcements, we usually can see the underlying business progress. Sometimes, we can pick up things that missed by the management. We can "smell" what is coming before the market price actions. And this is fundamental analysis.


In true sense of value investing, we would have dump the stocks when its balance sheets reflect a mediocre operations management with lackluster performance, with or without its subsequent financial troubles. With such complete fundamental analysis, the actions of value investors (to sell/ to avoid) always come much earlier than the market price actions.

Relevant resources: