Have you heard that not all stocks are the same and you need different methods to value them properly?
The reason is closely linked to the lifecycle of companies and there are four stages.
But are all stages worthwhile to put your investments? At what stage is your risk manageable and the reward substantial to generate a decent investment return?
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The Lifecycle Of Companies
The probability of a business failing is the highest in the first 3 years of operations. Many companies have to test the demand for their products or services in the marketplace. Those businesses which gained traction would be able to survive while the rest would fade away eventually.
The angel investors and venture capitalists are willing to put money in start ups as the gains can be astronomical if the businesses become successful.
The failure rate is so high that often investors spread their capital over several start ups to reduce their dependency on one company which has a high degree of uncertainty with regard to her success.
Companies who have survived the Start Up phase will enter a growth stage.
The company would be expanding in terms of revenue, headcounts, and market share.
The companies will need a lot of capital to implement their expansion plans. One of the ways to raise money is to list their business in a stock exchange. Prior to Initial Public Offering (IPO), bankers can sell pre-IPO shares at discounted rates to high net worth clients. Retail investors would only get to pay IPO price by bidding for the shares.
Companies that are successfully listed are trading at very high Price-to-Earnings (PE) and Price-to-Book (PB) because many investors are willing to pay for the potential future profits of these companies.These companies are also unlikely to give out dividends because they need the capital to grow their businesses.
Most people invest in this phase are believers of these growth stories. Unknowingly they have taken a long shot and assumed higher risks in the process. This is because many growth stories fizzle out many years later.
The companies at this stage have almost reached the maximum potential and growth had started to slow.
The familiar brands become the stalwarts in the industry and the stock market. These are the big cap blue chip stocks which are prestigious and powerful. They are able to turn in steady profits and give out regular dividends.
Many investors have their eyes on these stocks and believe nothing will go wrong with them. Analysts watch these stocks with keen eyes and churn reports after reports about them.
The smaller companies in the mature stage are often overlooked with no analyst coverage. They are less sexy than the big caps, and there were no more exciting growth stories about them. As such, the stock prices of these small companies are depressed and undervalued.
We pick our CNAV stocks from this group because the mature stage is the most stable stage (lower risk) and these stocks are very undervalued (potential higher returns).
This is the stage which every company tries to avoid.
Big caps can also enter the Decline stage if their businesses deteriorate. Undervalued small caps can also become cheaper if problems arose and persist.
What Does the CNAV Strategy Entail
The CNAV strategy is a form of value investing strategy, consisting of two key metrics:
- Pay a very low price for very high value of assets (but many stocks deserved to be trading at low multiples of their book value because of myriad issues. Hence, we need the next step to increase our success.)
- Use POF score to pick the good from the bad, in a pool of cheap stocks
Instead of taking the book value of a company, we know that not all the assets are of the same quality. For example, cash is of higher quality than inventories. The latter can expire after a period of time.
Hence, we only count the full value of cash and properties, and half the value for equipment, receivables, investments, inventories and intangibles (income generating intangibles such as operating rights and customer relationships. Goodwill and other non-income generating intangibles are excluded).
The step two test is termed as POF score (to minimise the probability of investing in a stock in decline phase)
While we emphasised on asset-based valuation, we look at earnings as well. The company should be making profits with its assets. If we realised by now, when we pay a fraction for its valueable assets, future earnings all come free to us. We do not pay a single cent for the potential profits.
We have to look at the cashflow to ensure the profits declared are received in cash. A positive operating cashflow will ensure the company is not bleeding cash while running its business. If it does, the CNAV will decline as the company has to raise cash by selling assets and / or borrowing money.
Lastly, we will look at the gearing of the company. We do not want the company to have to repay a mountain of debts going forward, especially if interest rate rises, it may dip into their operating cashflow, or worse, depleting their assets. Equity holders carry the cost of debt at the end of the day.
In short, CNAV stocks are stable small companies which are overlooked by most investors. These smaller companies offer a higher potential return because they are more undervalued than their bigger counterparts. This is consistent with the Fama-French Three Factor Model, whereby the two professors found that (1) small caps and (2) low price-to-book stocks tend to do better than the market as a whole. But these stocks are ugly and not sexy at all. It isn’t glamorous to own them. Investors want the ‘Louis Vuitton’ stocks.
Often we are blinded by ‘good’ companies and having the tendency to invest in them. But we must practise second order thinking. If everyone likes a ‘good’ company, and if the company is obvious to most that it is a ‘good’ company, there must be little chance for us to make good profits from investing in it. Therefore, we took a path less travelled.
For a video explanation of the lifecycle of a company, go to BigFatPurse’s Youtube Channel –> http://youtu.be/ImmZFRbT5t0