The Dean of Wall Street

Warren Buffett once remarked that he is a synthesis of "85% Graham and 15% Fisher". Fisher refers to Philip Fisher, the Californian money manager who advocated the importance of doing groundwork and speaking to people on the turf. He coined the term "scuttle-butt" to refer to his technique of relentless recee in his attempt to uncover investment gems.

Who is Graham then? Benjamin Graham is still fondly referred to and revered as the Dean of Wall Street. In the 1930s, he provided the investment community with the framework for security analysis when speculators were abound. Graham lectured Buffett at the University of Columbia and mentored Buffett in his early stages of his career when Buffett worked at his Graham-Newman investment partnership.

What is most interesting to me is that Buffett's superior return today was not the result of applying Graham's valuation techniques. Graham championed the "net-net" technique which calls for purchasing a company when its current assets exceed its total liabilities. Later in his career or life as both are intertwined for investing is a lifetime obsession, Graham also examined the merits of low P/E investing. However, a peek into the financials of Buffett's purchases over the years reveal otherwise. He is not into low P/E investing nor the "net-net" approach. This begets the question – where is Graham’s influence over Buffett?

The difference between investing and speculation
Graham made it clear that investing and speculation are different. He remarked that "almost by mathematical law, more speculators must lose than can profit." Speculators are playing the greater fool game - buying and selling the stock off to the greater fool - before the music stops. And history - whether it was the 1970s with the Nifty Fifties or 2000 with the dotcoms - has shown that the music will always stop. On the other hand, investing requires a through analysis of the company underlying the stock, understanding its strengths and weakness and its competitive environment.

The importance of the Independent Thought Process
While the investor must be respectful of the current market price or direction, Graham stressed that one must develop and retain his own independent thought and evaluation process. This means that the investor, through his own through research, should be able to form his own opinion on the attractiveness of the company and industry regardless of market sentiment. In the herd, one may feel the warmth but in investing, it is important to discern if the direction which the herd is headed is correct. The investor does not need affirmation from the crowd as to whether he is correct. In fact, it is usually costly if there is affirmation from the crowd. The investor is correct only because he has his facts and analysis right.

Mastering Market Psychology
"Mr Market" was a term coined by Graham to refer to the manic depressant which turned up every day (except on weekends) to provide a price quotation for a fractional share of the company ownership. Depending on his exuberance, "Mr Market" can offer sky high or depressed prices for a share. "Mr Market" is so ubiquitous today. He silently runs his quotes at the bottom of your television screen, provides updates on your favourite webpages and can even push prices to your handphones/pagers, almost begging you to transact with him.

Despite his pervasiveness, the choice to buy or not from "Mr Market" remains in the investor's hands. And the decision to buy comes only when the price quoted is more attractive relative to the investor's valuation of the company. This entails divorcing the market price from the true worth of the company. And true worth is established after the investor has completed his due diligence of the company and has done an appraisal of its prospects and established his valuation.

The Margin of Safety
The "margin of safety" is said to be the three most invaluable words in Graham's investment thesis. It means that the investor should only buy securities when the price quoted is substantially lower than what the investor thinks it is worth. The key lies in the word “substantial”. This concept is not unique to the field of investment. For example, in engineering, the electrical engineer would design a circuit that have the ability to carry, say 10 amperes of current, when it is envisaged that only a current of 5 amperes will flow through it. It would be foolhardy for the engineer to provide only for 5 amperes of current.

Hence, by insisting on a margin of safety, the investor provides himself with a cushion should his assumptions turn out to be overly optimistic or should unforeseen circumstances occur. This is especially essential because in investment, unlike engineering where the last decimal place may be pinned down, a lot of factors are qualitative projections and subjective assessments of the company, its industry and its management. This highlights the significance of performing a scenario analysis before a security purchase.

It is evident that the richness of Graham's works extends beyond his mathematical equations but to such intangibles which shaped the mindset of Buffett. I have not done justice to Graham's teachings and ideas by distilling them into this short note. Only direct reading of his pieces is adequate.

I was introduced to Graham at Borders bookstore when Regina informed me that Graham was the one who had largely shaped Buffett. I have offered myself to be shaped too as Graham's approach to investing is so compelling it provides a compass to navigate one through the vicissitudes that characterize irrational markets.

"I need to buy a REIT!"

I had spent half an hour explaining the structure of a REIT and its source of income before learning that so-and-so did not actually have a securities custodian account. This meant that this particular individual could not apply for the latest REIT initial public offer. And I ran into another who said that he simply needed to go out there and buy a REIT because he was unsuccessful with the initial public offering. To me, if you hear about an investment (class) being talked about in lifts and covered till death in the local press, it means that we could well have a bubble waiting to be burst!

When REITs hit our shores about three years ago, not many gave them a second look. In fact, the first offer failed and the offeror had to go back to the drawing board. It restructured and came out offering a hefty 7 or 8% yield in a low interest rate environment. The capital gains of the early REITs which ensued was the result of yield compression as investors piled into them and grabbed them like hotcakes in recent years.

Today, the REITs trade at between yields of 4.2 - 5.3%. Investors are still enamored by them for they offer the prospect of relatively higher yields and a hope that they will repeat the stellar capital gains. I found it alarming that today's papers described such yields as attractive compared to fixed deposits rates offered by banks. Well, yes if you compare yields alone and forget about your capital. If one parks his hard earned dollars in a fixed deposit account, the returns may not be compelling but he enjoys the safety of capital return (assuming no default risk by bank). With REITs, I am not sure if capital return is assured in the current or projected environment. Interest rates clearly on the up-swing with the US Fed continuing to chalk up steady increases despite Hurricane Katrina's devastation. When interest rates inch up, yields of REITs are likely to need to increase. This would then translate to capital losses for the investor!

The foregoing is clearly my current humble view towards this asset class and you may differ. If you still need to invest in one, purchasing a REIT with a clear acquisition strategy helps. As the acquisitions tend to be yield accretive, it provides a defense for yield de-compression. However, bear in mind that the manager's task is made harder when the portfolio of properties increase.

The REIT play

Initial public offers of REITs are snapped up like the proverbial hot cakes when they are offered. It's near to impossible to get one's hands on them these days. But are there other ways of benefiting from the REITs rush?

(1) Vendors
By divesting the property to the REIT, the vendor receives cash which it may invest in other more profitable projects or to pay down its debt. A good example of a property developer disposing some of its assets and on-investing them in Chinese projects is Capitaland. Other SGX listed companies have also sold properties to REIT. Freight Links have sold several warehouses. Armstrong, Osim and TT International also come to mind. But will the proceeds be used wisely?

(2) Would be vendors
Market talk is that other companies with property portfolios on their books may be interested to also hive off their assets into REITs. With an ex-CEO of a REIT on board, the moves of F&N cannot be more overt. Or what about Cheung Kong who may potentially spin off more assets on its books into REITs?

(3) "Spill over" effect
When Prime REIT goes to the market, it will provide a benchmark to revalue other assets along Orchard Road. Bonvests which holds Yishun Ten and Liat Towers, of which the latter is a stone's throw from Wisma Atria, saw trading activity pick up. It's still trading about 50% under NTA. Paragon is held by SPH but the valuation of SPH may have fully factored in the possible sale of the properties. Or look across the road from Wisma to see CK Tang?

What's illustrated in this short post today is that there are other means of benefiting from this "REIT rush". Of course, never forget to do one's due diligence.

Sometimes they don't add up, do they?

WBL (13 Sept 05) S$3.40.

WBL is a conglomerate listed on SGX. It is closely held by the OCBC Group of companies - GE Holdings (20.7%), Straits Trading Co (11.0%) and OCBC Bank (6.1%). Recently, it was in the news in its failed bid to privatize Wearnes International. Other than Wearnes, it holds large stakes in two other technology companies, namely, Multi Fineline, a Nasdaq listed company and MFS Technology. The latter is listed on SGX.

We attempt to do a simple sum of the parts valuation to ascertain if WBL is trading at a fair price today.

(A) Stakes in companies which are listed
Entity -- WBL's stake -- Mkt Price -- Mkt Cap -- Value
Wearnes -- 85% -- S$1.27 -- S$250 mil -- S$212 mil
Multi F -- 57% -- S$43.00 -- S$1032 mil -- S$588 mil
MFS Tech -- 56% -- S$0.55 -- S$355 mil -- S$199 mil
TOTAL: S$999 mil

(B) Stakes in companies which are unlisted
WBL holds stakes in several other technology and biotechnology companies. It also holds investment properties. As it is difficult to value unlisted entities and properties without performing a revaluation, we shall conveniently assign zero value to WBL's portfolio of unlisted entities.

Shares outstanding: 172 mil.
Therefore, value per share = S$5.80.

At today's price of S$3.40, this represents approximately 40% discount to its value. When will the value be unlocked? It's anyone's guess.

Cheap pair of wheels?

PT Astra (ASII IJ) Price as at 12 Sept 2005: Rp11,150 (SGD 1.84)

Astra was listed in 1990. It is an Indonesian conglomerate focused on the automotive sector, where it has dominant market share in the domestic car and motorcycle segments. About 56% of its 2004 earnings was contributed by the motor vehicles segment. Other significant earnings contributor is financial services (17%) and agricultural business (palm oil) (11%). With its diverse business, Astra is clearly not easy to value or understand. Over 50% of Astra is held by Singapore listed Jardines C&C. Since acquiring a 39% stake in 2000, Jardines has quietly chalked up its stake. Toyota holds a token 4.8% stake.

Astra's financials are healthy. Over the last 4 years, its ROE is at least 38%. Although financial leverage is fairly high (at 2.4x), the company has gradually reduced its debt over the years. Net profit margin has consistently been at least 10%. Its ROC is a healthy 25% over the last 3 years.

Risks remain. Astra is entering unchartered waters by undertaking a venture into infrastructure projects (power plant and toll road). These projects necessarily requires high capital expenditures and will erode the amount of available cash for dividend payments of an otherwise generous dividend paying company (dividend yield of about 5%). On the flipside, should these ventures pan out, they offer the promise of strong cash flow generation potential.

The Indonesian government has indicated that they would gradually wean the population off fuel subsidies which have kept petrol prices artifically low. This development may translate to less demand for motor vehicles. With rising interest rates, consumers are also less likely to undertake financing to purchase motor vehicles. In fact, Astra's management has reportedly guided that sales are expected to be flat in 2006.

In addition, automobile industries are known to be cyclical, frequently correlated to the health of the general economy. In 1998 during the financial crisis, Astra's sales plunged about 70%. Hence, its sales are likely to suffer if Indonesia slides into a crisis as a result of surging oil prices.

Since 2001, Astra started generating healthy free cash flow. Using a variant of a discounted cash flow model (using assumptions of 5% CF growth in next 10 years, 0% growth subsequently and a hefty 10% discount rate), Astra is estimated to be trading at about 25% discount of my intrinsic valuation estimates. This translates to a target price of Rp14,970.00.

Does the perceived discount of 25% provide sufficient margin of safety to purchase a difficult of understand conglormate with the risks highlighted above? Only time will tell.