Looking for Opportunities in China

The rapid growth of the Chinese economy has forced investors all around the world to pay attention to it, and there are very few businesses that have not been impacted by the awakening of the Dragon. Yet the opportunities that the Chinese market provides bring risks as well. Here are some things to look out for in a company that is competing in the Chinese market:

The Chinese market is huge, and so is competition. Companies which are unable to articulate a strong competitive advantage will find it difficult to survive the onslaught from counterfeiting, piracy, and sheer will of the Chinese themselves to compete away the profits of others. Any product or service which is not able to differentiate itself adequately will quickly become a commodity. As such, companies with established records in developed markets tend to have a greater chance of doing well in China. Their track records of success in developed economies such as USA, Hong Kong and Singapore show that they have quality managerial expertise, quality products, and/or an established brand name which are more likely to withstand the intense competition that they will face in China.

Examples that have succeeded include household brands like Mercedes Benz, Starbucks, McDonalds, Las Vegas Sands and OSIM. They all have established brands in developed economies and have proven business models. Conversely, a company which is simply banking on "the huge China market" and "immense opportunities for growth" and does not have a proven business model will find it difficult to survive in the ruthless environment that is characteristic of the Chinese market.

The Chinese economy also has problems with the enforcement of patents and intellectual property. Bill Gates should know: the vast majority of Microsoft software being used in China has not been paid for. Hence, business models which are not dependent on the existing legal framework to enforce property rights will have a better chance to succeed. Examples of sectors which fit into this category are, transport & logistics, natural resources, food & beverage, computer hardware (even this sector faces problems, though) etc. Examples of sectors which will face intense counterfeiting are digital media distribution companies like video, music, computer software etc. One example of a company that is able to circumnavigate the piracy problem is Blizzard (Vivendi Games) - its World of Warcraft game software is based on a subscription basis, which is not subject to piracy.

Another important point about investing in China is that the ability to compete on costs is not enough. Many manufacturing companies have relocated to China citing lower labour costs as their source of competitive advantage. This advantage may exist for a short while, but for most who entered the market on this premise, the cost advantage has disappeared. Intense competition has competed away this advantage; meanwhile, wage rates have begun their ascent. Municipal governments are starting to impose mandatory wage rises. And the businesses which only compete on costs have suffered as a result. An example of this is Creative Master. A company must not only be able to compete on cost, it must be able to compete based on quality and have other differentiating factors, so that it can establish some pricing power. Haier, for instance, has done so, and is now a global player in the white goods market.

In short, the sheer size of the Chinese market makes it a very tempting one to enter. But just being in the market is not enough. When researching a company, one should look for clues that indicate that it will be able to withstand the intense competition that it is bound to face. Only after establishing this should an investment be considered. Many have bePublishen burnt by the China story, and many will be in the future. Let's hope you're not one of them.

The Difference Between Price and Value

Many people think that the value of something is the price that others are willing to pay for it. And to some extent, that is true. However, when investing in stocks, this kind of thinking is very dangerous, and can be extremely damaging to your bank account. It is the investor who knows the difference between price and value who will prosper.

So, what is the difference between price and value?

The price of a stock is quite simple - it is simply the amount at which the stock was last transacted on the stock exchange. You can find it by looking up the financial pages or on a website like finance.yahoo.com

The value of a stock, however, is a different matter altogether. To understand what the value of a stock is, one has to first understand what stock is.

Stocks in a company, or shares in a company, are a piece of property that gives the holder ownership rights to a portion of a company. An owner of stock in a company has a proportionate claim to any future dividends that are paid out by the company as well as any voting rights which give the shareholder to have a proportionate say in matters during shareholder meetings. In the case of a winding up of the company, the shareholder also has a proportionate claim to any residual assets that remain after all other creditors have been paid.

The value, or “intrinsic value”, of a stock is thus the present value of the future cashflows that can be derived from the stock (known as net present value calculated by discounted cash flow analysis) or the net liquidation value that is due to the stockholder in the case of a winding up.

It should thus be obvious that the intrinsic value of a stock can often be a subjective thing - different people will have different estimates of intrinsic value depending on how they foresee the company performing in the future - a person who predicts a strong growing company will have a higher estimate of intrinsic value than a person who believes the company is going to perform poorly.

But one thing is for certain - price is NOT value. Price is simply the amount that two people came to an agreement over which to allow the stock to change hands. Nothing more.

Price can differ from intrinsic value, and often does - and the astute investor tries to buy a stock when its price is trading significantly below its intrinsic value, and sells the stock when the price goes above intrinsic value.

And it is because he understand that price and value are not the same thing, that he is able to profit from this method.

Even Harvard Students Don't Seem to Know Any Better

Research by three academics at Wharton, Yale and Harvard suggests that superior investment judgment is not a function of superior access to information, nor is it a function of superior academic intelligence.

The article: “Today’s Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” from Knowledge@Wharton, is about experimental research done on Harvard undergraduates and MBA students.

The students were, for all practical purposes, given equal information about four different index funds, all of which contained the same securities. The only difference between the funds was the management fee structure. Yet, they overwhelmingly failed to make the optimal investment decision: to focus their investment into the index fund with the lowest management fees.

The students were misled by irrelevant information showing “annualised returns” (a moot point since going forward, all the funds had the same securities in the same proportions and would thus perform identically, apart from management fees), and also diversified their investment into several funds, even though there was absolutely no diversification benefit to be gained from investing in more than one fund.

This research thus suggests a few important things:

1. Superior investment judgment is not a function of superior academic ability. We can safely assume that the Harvard undergraduates and MBA students represent the cream of America, if not of the world. Yet they overwhelmingly demonstrated inferior business judgment. Hence, If you are evaluating someone as a potential manager of your money, it is irrelevant to look at his or her academic credentials. Superior investment judgment is a function of something else. And that something else is not academic intelligence.

2. One does not need superior information to make superior investment judgments. The notion that one needs to have better information than the next person in order to make a better informed judgment, is a myth. As a result of this research, it seems investing is akin to the game of chess - where the participants in the game both have complete access to all relevant information - the one who wins is the one who has the superior ability to synthesize and evaluate the available information, not the one who has better access to information. Hence, it is wise for investors to avoid any such schemes which claim to have “superior inside information.”

3. Another important implication of this research, and perhaps the most profound of all, is that having complete information does not necessarily lead one to make the optimal investment decision! In other words, markets are not efficient. The efficient markets hypothesis holds that markets adjust rapidly and rationally to take into account available public information, and that market valuations are thus optimal or rational. Yet the research results indicate otherwise: 80% of Harvard students were unable to come to the optimal investment decision, despite them having all relevant information required!

If the vast majority of the intelligent population is unable to make optimal investment judgments given unhindered access to information, how can markets possibly be efficient? The notion that markets are efficient i.e. that securities are always priced rationally, must necessarily be thrown out of the window. This has profound implications for supporters of such theories as the CAPM or MPT (i.e. the vast majority of fund managers) - and provides support, once again, for Graham & Dodd’s theory of intrinsic value i.e. the best way to invest is to purchase securities trading at a substantial discount to their intrinsic value (i.e. when markets are behaving irrationally), and sell them when they are trading above intrinsic value.

In short, this research provides proof that investing is, ultimately, a game of skill, and that those who have superior ability will ultimately outperform those without.

Using the Internet to Aid Your Investing

The world of investing can be daunting to those who have just begun to learn about the subject, and for those who have yet to begin. Indeed, with the multitude of terms to learn and concepts to understand, a guide to get you started on the basics will certainly be very helpful. Thankfully, there are various resources on the internet to assist you in your quest to invest. Here are a few helpful links:

Five Steps to Follow Before Buying a Stock

When analysing company, one should do both a qualitative and quantitative analysis of the company before deciding whether to buy its stock. Here are the things to consider:

A. Qualitative Analysis

1. Market Environment - An ideal company is competing in a market that is growing. This allows the company to participate in sales growth without necessarily having to take away market share from its competitors. Furthermore, in the same way that a rising tide lifts all boats, so a rapidly expanding market is a boon to most companies in the market.

2. Competitive Dynamics - A rapidly growing market is ideal, but a company will have much greater success if it is able to create a competitive environment where it is able to maintain its profits and fend off competitive threats from its suppliers, buyers, substitute products and potential competitors, in addition to dealing with its existing rivals. A favourable competitive environment, coupled with a favourable market environment, often give a company a high chance of success. For more on this, click here.

3. Internal Capabilities - In many ways, a company's own resources, strengths and capabilities help to shape its competitive environment. Companies with strong capabilities in areas such as branding, product development, research & development and human resources can often create very strong barriers to entry in their industry, as well as dimishing supplier and buyer power. The quality of management often plays a big role in determining a company's capabilities, so understanding the key officers of a company can be crucial to analysing a company's prospects.

For an in-depth example of a qualitative analysis of a company, peruse Blackmores - A Strategic Analysis

B. Quantitative Analysis

4. Financial Statement Analysis - This involves breaking down the various components of the balance sheet, income statement, and cash flow statement to determine the various characteristics of the business. Various ratios can be calculated to determine financial strength, asset utilisation, profitability, and the quality of the projects the company is pursuing. These ratios include debt/equity ratio, return on assets ratio, return on equity ratio, asset turnover ratio, and gross and net profit margin ratios. A comparative analysis of a company's ratios with others in the same industry can help to identify who are the market leaders and who are the market laggers.

5. Investment Valuation - Valuation involves using various valuation technologies to decide on how much a stock is worth. These tools include, the dividend discount model, the discounted cash flow models, residual income model and abnormal earnings growth model, amongst others. When valuing a company, one has to bring together the analysis in the preceding four steps to project the future revenues, costs, cash flows and other financial numbers, before inputting these numbers into the valuation tool to arrive at the intrinsic value of the company.

Making the Decision

After one has gone through steps 1-5, the investor compares his valuation of the company with the market price. If the market price is above the intrinsic value, the investor does not purchase the stock. On the other hand, if the market price is significantly below the intrinsic value, then it may be an opportunity to buy the stock. For example, suppose one decides that the intrinsic value of a company is $1 per share, and the market is trading at $0.70 per share, this represents a 30% margin of safety, and looks like an attractive buy. In general, I look for at least a 25% discount to intrinsic value.

Valuation in Practice

Analysing a stock often involves making many subjective judgment calls about the market, the competition and the company. Even after making these subjective judgments, one has to translate this analysis into numbers, which can also involve many estimates and educated guesses. By insisting on a strong margin of safety, one can err on the side of caution, and avoid the cost of expensive mistakes that investing can often bring.