I've been wanting to write on this for some time but find it incredibly difficult to organize my thoughts and do so.
When I saw fellow bloggers write about their thought process on their preference and methodology on selecting stocks, it helps a lot because there are so many ways and path that we can reach to Rome.
- Azrael talks about his method of valuing stocks using fundamental analysis here.
- Chin Wai talks about his method of valuing stocks using Price to book value here.
- STE talks about his method of valuing stocks using the regression method here.
When I was at the sharing session a few weeks ago, someone came to ask me how should they come about to select stocks. It is a very common yet difficult question to answer because there are so many ways that you can come across to look at it yet giving that answer was not the easiest for me. I was dumbfounded.
Since then, I came home thinking hard over the next few weeks how should I translate this thinking into something practical that many people can relate to. If we talk about using the low price to earnings or low price to book value, everyone gets the concept but they will find it difficult to apply in real life. If you talk about using the screening filter, again it's not scientific and coded about using what sort of information is the best.
|Putting on my thinking cap|
My Thought Process
Here, I am going to attempt to translate my thought process into something mathematical, something which everyone is familiar with. I thought having such thought process is important because it gives me an indication and guidance when I am faced with many hurdles, temptation and questions and being able to justify why I select certain companies at certain times that meet my criteria becomes the utmost importance in my investing journey.
Before I begin, I need to stress once again that this is purely based on my personal thought process so any individuals could disagree or have a different opinions and it totally make sense.
X + Y + Z = Total Returns
where X represents the Dividend Yield (%), Y represents the Dividend Growth (%) or Capital Gain (%), and Z represents the valuation factor.
X - These represents the dividend yield (%) of a company which is pretty straightforward. There are some questions on whether one should use the historical or forward dividend yield and I will address that in a while below but for this purpose I will use X as a determinant for historical dividend yield. This is a known factor which you and I and everyone else know about it.
Y - This is the crucial part here because almost everything revolves around this factor and the amount of competency that you have and put in researching and forecasting will determine the total returns that you will get. Here, I am putting this to represent the dividend growth (%) or capital gain potential (%) because for simplistic reason I am assuming that if the company has positive dividend growth, it assumes that earnings and cashflow are better and thus the share price would reflect a higher price in order to justify the same yield as they have previously.
For example, if I assume that Singtel is going to increase its dividend from 17 cents to 19 cents next year because earnings and cashflow are better, that would represent a 11.7% increase. This means that I will mathematically put Y = 11.7% in my head and assume that the market would account for a corresponding 11.7% increase in the share price. It will not be exactly the same amount, but the theoretical concept is usually the case.
Similarly, Y can also be attributed to negative growth. A very good example in recent case would be Keppel or M1, which is an extremely hot topic these days.
For theoretical example, should M1 decides to cut their dividend from 15 cents to 13 cents next year, this represents a (13.3%) decrease. This means that I would attribute Y = (13.3%) and would account in my head that I am expecting market to discount the share price by the same percentage point.
To reiterate once again, to be able to forecast Y requires many years of competency of understanding the business and the industry.
Z - This is where valuation would come from. Valuation can come in many forms and I will not be going into the detail here. If you are interested to learn more on valuation, you should look out for Prof. Asmoth Damodaran blog as he detailed out each individual valuation methodology and dissect them to the very detailed.
The general idea to take away here is that if your X and Y sucks, you can still get a good deal out of your investment assuming your Z value is high. There is no hard and fast rule on what you should be putting for Z but generally the cheaper the valuation the higher the value of Z be. On the other hand, if your X and Y are good, the Z value is usually very low because you will see companies that are stretching at overvalued proposition. Shengshiong and SATS are two very good example of such in my opinion.
Total Returns - When you combine all three factors, X + Y + Z, you should ideally get a rough idea of returns that you are expecting for. This can vary among individuals depending on their appetites and competencies. For myself, I am expecting a total return of 10% / year for each investment I made. This means that I usually have to work out between the three factors which of those that I wanted to focus on and get a better clarity.
My Favorite Strategy
Obviously, the best you can get out of your returns is through achieving a high X, high Y and high Z. While they are not impossible to find, they are not easy to detect as well because for most of the part the Y and Z function are unknown factor where individual competencies and time investment put into the research matters. So I won't be stating the obvious for the purpose of this exercise.
1.) High X + High Y + Low Z = In Excess of 10%
This quickly becomes one of my personal favorite strategy in recent times because I've been looking for companies which are catalyst driven. What this means in terms of Y is that I am usually expecting earnings and/or dividends to be part of the catalyst which would eventually drives the share price up. This is usually a short term holding and as soon as those catalysts are executed and announced in their financial results to the public, I will divest them for a profit taking.
In my current portfolio, Micro-Mech and UMS (both recent additions) falls under this category as both companies owns good balance sheet, good cash flow, high dividend yield and a stronger semi-con industry demand set to grow in 2017/2018 means that demand order will grow.
2.) High X + Low Y + High Z = In Excess of 10%
Sometimes, I find it difficult to find companies which displayed the above attributes for short term profit taking. Hence, I will delve down to the next option.
This is usually a long term holdings because of the high dividend yield and decent valuation, which warrants a hold in the portfolio.
In my current portfolio, Ireit, First Reit and Ascott Reit would fall under this category due to the nature of the structure of Reits they are in. All of them provides high dividend yield and a decent valuation, though for Ireit and First Reit I am still secretly hoping for a high dark horse Y factor (I spoke of this in my sharing seminar on the self-reinforcing cycle).
3.) Low X + Low Y + High Z = In Excess of 10%
Some of the developers which I have bought in the past would fall under this category. A good example would be companies such as CDL and Ho Bee, both which I have divested since, are providing low yield with no catalyst in sight but their valuation is so cheap that at times they might warrant a buy and keep.
Personally, I'd prefer to avoid such companies for now because of my biased preference towards a high dividend yield (high X) these days but I will keep an open mind should such opportunities arise.
4.) Low X + High Y + Low Z = In Excess of 10%
I personally suck at this strategy where a company could display a potential growth story which would eventually push the valuation even higher. I just simply don't know how to work out at such strategy so it is extremely rare that I will own such companies in my portfolio.
Osim, Super Group, Sarine, Straco are example of such companies which would fall under this category and as you can see most of them have tripled or quadrupled in value if you can get it right.
This is just some of the things that is going through my head when I invest that I am sharing with.
As mentioned earlier, everyone has a different preference profile towards their investing strategy and it is important to find your mojo that suits your profile than following others. For instance, my biased preference towards a high dividend yield (but must be sustainable) to suit my cashflow needs may not suit others who feel that they want growth in their companies.
I hope this helps someone to have things to think about in their head when they are choosing between a few stocks to invest in with their money.