Wednesday, July 30, 2008

Feeble defense of Hongcheng

What an interesting forum!

Someone launching attack on FA people on huatopedia. Basically, millionairemind is trying to question an assumption held by some- that there is a PE where the stock will not go any lower. The thread is about busting common investing myths - excellent discussion going on there :)

He argued that,

"If a stock you are looking at has a PE ratio of 6 and growing at a reasonable 10-15% a year, with low debts, would you buy it??? Sure, most FA will say... Remember, the value of a company is what the market prices it at...

If you have bought it at a PE ratio of 6 around 50cts... you would have lost 60% OF YOURE INVESTMENTS BY NOW!!! Would you buy more at say 50cts?? How about 40cts?? 30cts??? It is now 20cts and change. It has a PE ratio of around 3 now. And the SAD news is that this is NOT A MONEY LOSING COMPANY!

The 9months earnings so far is up about 25% YOY. The earnings is of course decelerating but not the company is not making a loss... that is what I mean by the market always knows better and without institutional support, the stock will not move."

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Well...let me try to piece up a feeble defence. I have no presumption that I know anything. But firstly, I don't buy just based on PE. In fact, PE is just one of the way I used to calculate the rough range in which the stock will trade. It will never be a valid reason to buy just based entirely on PE. To me, it's a little over-rated. Secondly, it just got IPO-ed on 8th August 2007, meaning that it's just slightly short of 1 year. I personally won't buy IPO stocks (because no matter how much I tikam, I always didn't get any lots!) because the results could be adjusted to 'prepare' for the IPO. I prefer to have it for 5 years at least to have a feel of the company's business before even entering it.

I tried to search for China Hongcheng results - they only have from FY06 to FY07, and 1st to 3rd quarter FY08. Let me ignore quarterly results for now.



I hate doing companies with very short history. Since FY06 is pre-IPO, we mustn't treat it too seriously - this means only one year worth of data.

At first glance, seems like this company's business is doing well. With a gross margin of around 29% and a net margin of 16-17%, it seems rather profitable. ROE of 50%, that's very very high. Let's break down ROE of into 3 components:

1. Financial leverage : Total assets/Total equities

2. Asset turnover: Total revenue/Total assets

3. Net margin: Net profit/Total revenue

ROE = Financial leverage x asset turnover x net margins

Yr---------Financial leverage-------Asset turnover-------Net margins---------ROE
FY07------------4.56--------------------0.70---------------16.7%------------53.3%
FY06------------6.78--------------------0.64---------------12.8%------------55.4%

Seems like the reason for their high ROE is from their leveraged structure. Indeed, looking at the current and quick ratio suggest a rather low figure. Total debts to equity paints an even worse picture. If I'm interested in the company, I would do a comp study on other similar companies. Take note that the below comp table is lifted from their presentation slides, dated Oct, 2007. I wonder what the PE of the comparable companies will be like now. Perhaps it will show that Hongcheng at PE of 6x or even current PE of 3x isn't that fantastic.



We can see that the ROE of china hongcheng is one of the highest. But we must break up the ROE to see if the ROE is boosted by high borrowings or not.

Below is the price to EPS (SGD) for China hongcheng,

Year------price(high)----price(lowest)----EPS---------PE(high)-------PE(low)
2008-------0.35-----------0.185--
2007-------0.58-----------0.33----------$0.066---------8.8------------5.0

* note that highest and lowest price is the closing price, not the intraday high or low
** EPS is in SGD

Data of historical PE is too little to be of much use - that's one of the reason why I won't buy IPO stocks with less than 5 years of history behind them.

One thing that screams loudly as I was browsing through is the fact that around 70% of their revenue comes from overseas in FY07 and of that amount, 42.4% comes from US. That's like 30% of their revenues from from US. I'm wondering if their business will be affected adversely should US suffers a slowdown or recession in their economy. Hmm, food for thought.

Of their business, their should start to increase selling more bed linens. My goodness, those have a gross margin of 41%, but takes up only 8.3% of revenue. Most of the product revenue comes from selling grey and dyed cotton fabrics (53.8% of revenue), which earns a gross margin of 21%. Didn't know bed linens can earn so much :)

I guess that's my feeble defense. I don't even think it's a defense, haha, I'm just thinking out loud on this company. I anyhow anyhow did some valuation, using 10 yrs with no terminal value, discount rate of 8% and EPS growth of just 10% (it's around 20%) - I get around $0.80 per share. Seems like good value at current price of $0.20 - I'll likely get like 15% returns in 10 yrs. But this company is too young to be sure. As long as the EPS grows up by than 10%, I think roughly roughly lah.

Don't hurt me too badly, millionairemind :)

11 comments :

musicwhiz said...

LP,

Your defence is sound. If one used value investing techniques, one would probably pass over HongCheng. PER is but one measure of a company but is certainly not the only one.

MM mounts a spirited "attack" but sometimes other factors need to be considered. Investing is not as simple as it seems (to me at least !).

Regards,
Musicwhiz

la papillion said...

Hi mw,

Thks for your encouragement!

Well, let's see how MM counter-attack. It'll be a good lesson to learn from this debate, no matter the outcome :)

Hongcheng looks interesting. Keep in view for now though.

Createwealth8888 said...

2 reasons to buy stocks:
1)Expecting it to go up
2)Short covering

4 reasons to sell stocks:
a) Profit taking
b) Short selling
c) cut losses
d) forced selling

This is the way how market set its price, the balance of force between potential buyers and sellers staying at the sideline. Potential buyers and sellers are the ones setting the stock direction.

la papillion said...

Hi bro8888,

Thks for your systematic listing of reasons to buy and sell :)

I think there is one more reason why people want to buy stocks. To get dividends. Some people didn't know that after XD, the price of the dividend yielding stocks will go down the same amt as the dividend given (theoretically) on opening. Well, I did made that mistake before, luckily someone stopped me, haha!

Createwealth8888 said...

Don't think it is wise to buy stocks just for dividend. Dividend should be the safety net if price falls.

Can't really buy a falling stock just because of the dividend yield keep increasing

la papillion said...

Hi bro8888,

Ya, I agree. To buy stocks just for the attractive dividend is foolish, because it might not even be sustainable.

The company I bought into last time was robinson, when they are giving out fat dividends. I thought I can hold onto it till XD then get the dividends, but luckily a friend stopped me. I dug out more and realised that the stock will drop to the same amt upon XD. I did make a handsome profit from selling before XD though :)

From then now, I never bought companies based solely on dividends. In fact, dividends is like bonus. If they give it's okay, if not, they can always reinvest in themselves for more earnings - we'll still get the capital gains from brighter prospects and growth.

Anonymous said...

Hello La Pap Brother,

You got a good blog going on here.. I will switch by when I got a chance.

Just to put up a small feeble defense again.. I am a FA person.. in case you are wondering... a CANSLIM practitioner is a FA person at heart.. he uses TA to time his entry into the market.

My aim is to debunk the investment myths out there.. as I hope for all the debate on-going and with charts and logical reasoning.. so that we can all benefit.

Huat ar,
mm

Mike Dirnt said...

8888 you may have valid reasons about the sell. but if you follow that analogy then the long term market will not be an uptrend. :P

LP to me HC has high ROE but low ROA. that means it is too highly leveraged. a good company with low leverage should have high ROE and ROA

la papillion said...

Hi mm,

Thks for your encouragement :)

I know canslim practitioners :) In fact, O'neil is the FIRST book that I read about that includes a little fundamental analysis inside. Last time, I was all symmetrical triangles, support/resistance, wedges and such :)

I just found out that I am not so suitable for O'neil's method, so I didn't pursue further :)

I took up the feeble defense so that I can learn from it. Haha :)

la papillion said...

Hi Mike,

Yes, I agree with you - HC has high ROE but low ROA. It seems like a business which is highly leveraged, sells for high margin but had low turnover. But I think it's more fair to compare HC with their comparable companies. The presentation slides given by HC to one of the results actually had the competitors - so one just had to do a similar calculation to see how HC compares with them. Maybe for this industry, the figures for such companies are the norm?

the pixie said...

did an evaluation on hongcheng. stocks seem undervalued though.