Editor Notes: Factor Investing is an evidence-based approach that aims to achieve 100% gain per stock – with annualised portfolio returns of 15-20%. The purpose of publishing our case studies is not to entice you into investing in the hopes of overnight fortune. All investing comes with risks. We Dr Wealth, and any of their associates will not be liable for any losses incurred in your investments. We hope that this case study will help you become a better investor.
In today’s case study, we’ll share how Terence Ong used the Factor Investing Framework to gain 250% returns (or about $10,000) on Nico Steel Holdings (SGX: 5GF).
Naturally, we reached out.
In today’s article, we’ll cover:
- How Terence Ong found Nico Steel using Factor Investing and how you can do the same
- CNAV Strategy: A 3-step approach to finding undervalued stocks
- Step #1: Find out the CNAV discount to know whether it is undervalued
- Step #2: Check the POF Score (Profitability, Operation Cash Flow & Financial)
- Step #3: Conducting a 3-Point Qualitative Checklist – Corporate Actions, Dominant Assets & Trustworthiness
- Price Plunges 50% to $0.002, What Did Terence Do?
- Was Terence Just Lucky?
How Terence Used Factor Investing to Find Nico Steel Holdings
Right after graduating from our course, Terence realised that the Value and Size Factors would produce excess returns.
He went to screen for undervalued stocks and shortly found that the entire steel industry was undervalued. Steel is a cyclical industry, with downturns and upturns.
And Steel was in a pretty big downturn that year.
When the entire industry is down as a whole, healthy businesses with great financials survive while the lousy businesses die off. Identifying and buying the great companies is what allows us to profit from the upswing.
In using the CNAV strategy, Terence also placed greater emphasis on the Value and Size factors.
The below graphs show the difference in average monthly returns for stocks with high Value factors vs stocks with low Value factors.
The stock with the highest Value factor outperformed the stock with the lowest value factor by an average of 1.63% a month. That’s a difference of 19.56% a year!!
Similarly, stocks which are smaller in market capitalisation over time deliver greater returns (1.47%) when compared with larger market cap stocks. That’s 17.64% a year!
Combining the two factors, Value and Size, meant that Terence naturally targeted stocks which while smaller in market capitalisation, delivered returns far in excess of what the market was capable of providing most retail investors – just like Terence managed to with250%+ gains.
Yet, Factor Investing is not new. Academics studied Warren Buffet’s methods, and found that even the Oracle of Omaha himself naturally picked stocks which exhibited certain factors.
BlackRock, currently the world’s largest asset manager with over $6.5 trillion in assets under management also applies Factor Investing. It was the first to start a fund based on it in 1971.
You can read more about Factor Investing over here written from the retail investor’s perspectives.
Let’s move on to how Terence used our Factor Investing strategy: Conservative Net Asset Valuation (CNAV) to evaluate and select a deeply undervalued stock: Nico Steel Holdings.
CNAV Strategy: A 3-Step Approach to Finding Undervalued Stocks
The Conservative Net Asset Value (CNAV) strategy is a Rule-Based Process we use to exploit Value and Size Factors under the Factor Investing framework.
We focus on stocks with small market capitalisation that trading below their net asset value.
The strategy consists of 3 steps.
- Determining the Conservative Net Asset Value (CNAV) discount. To value the stock and determine whether is it undervalued.
- An adapted Piotrosky F-Score: We score the company on Profitability, Operating Net Cash Flow and Debt ratio. To check for sustainability of assets and value traps.
- A 3-Point Qualitative Checklist. To further check for other risks that may impact the company valuation.
And lastly, we want to buy the stocks below its CNAV and sell the stocks at Net Asset Valuation(total assets minus total liabilities).
Step #1: Find the CNAV discount to know whether it is Undervalued
This is the first, most crucial step. It is important for you to understand that the steps are laid out in order.
If a company fails the first step, we no longer continue checking it.
We move on to the next company.
This is the formula we use to calculate a stock’s Conservative Net Asset Value:
Good Assets are defined as Cash, Cash Equivalents, Lands and Buildings.
These are the primary assets that we want to be paying for when we purchase a stock under the CNAV strategy.
IGA: Receivables, Investments, Inventories, Intangible Assets.
These are assets that help the business produce income so we will want to include them. However, they are less reliable than Good Assets. Sometimes, customers can default on paying you, so your receivables suffer.
The same applies to other components of Income Generating Assets. Remember that the earnings of a company can change rapidly, but its assets, will change far more slowly.
That is why we apply a 50% haircut on Income Generating Assets.
You can find its income generating assets under Assets section in the Statement of Financial Position.
This is the breakdown of Nico Steel’s relevant financial metrics in 2017.
Our calculations showed CNAV value to be $0.016. Price per share for Nico Steel was around $0.004.
Net Asset Valuation placed per share price at fair reflected value to be about $0.034.
Since the CNAV price was below the price of the share according to the market, the decision was made by Terence to continue investigating this CNAV Stock.
Continue investigating. Not buy.
Please do not jump the gun.
Step #2: Check the POF Score (Profitability, Operation Cash Flow & Financial)
The next part for Terence to do was to determine the company’s financial health, or its ability to maintain its assets.
This is critical since we do not want the company’s assets (which we are buying) to be in danger of being dissolved or liquidated, thus lowering our investment’s potential.
Let’s show you how to check that.
P – Profitability
While we do focus on buying assets, we do not discount a business’s profitability as well. The fundamental rule of business is that it has to be profitable. No company can sustain long term lack of profits without significantly depleting its cash and asset bases.
We can check on the company’s profitability under the consolidated statement of profit or loss.
O – Operating Efficiency
Cash flow is king in businesses. A chicken rice stall cannot operate if it cannot pay its supplier for chicken, its salary to its staff, and the PUB for its electricity. This is the same for all businesses.
Get it in your head.
We can verify that the company has had positive cash flow via its consolidated statement of cash flows.
Remember that it must have positive cash flow for two years out of three years.
This is the key criteria. It cannot fail this criteria. Failure of this criteria disqualifies the company from being invested in. That is how important this criteria is to the fundamental survival of the business. If any of the Hyflux investors had seen and understood the company’s financials, they would never have dared to invest in it.
Remember that one financial statement represents only 2 years of statements. The 2017 statement will reflect the 2016 statement as well. You will have to download and look at the portion under 2015 as well to determine that it has 2/3 years of positive operating cashflow.
F – Financial Position
Lastly, we will look at the gearing (debt) of the company. We do not want the company to have to repay a mountain of debts going forward.
Should interest rate rises, the company may have to dip into their operating cash flow or even deplete their assets. As an investor, the burden of debt will ultimately trickle down onto your investments. Therefore, it is critical to determine that the company is not overly geared.
You can look at a company’s statement of financial position to determine its debt. Also read up on any bonds or perpetual securities it holds. Alternatively, you can just Google the company’s Debt to Equity ratio.
Generally, we want it as low as possible. For CNAV, our acceptable limit is a debt-equity ratio of less than one (meaning Debt: Equity is 100% and below).
Nico Steel’s POF Score as of 2017: 3/3
Nico Steel as of 2017 passed 2/3 POF scores. It failed the profitability portion since it had a net loss for the financial year ended 28 Feb 2017 but it passed the operating cash flow and debt portion (less than 1).
It had 2 out of 3 years of positive cash flow and it wasn’t overly leveraged since its debt to equity ratio was 0.83 (below 100%).
So far in, Nico Steel Holdings had passed the numbers test.
Now let’s take a look at the third and final step. A qualitative look at what the business has been doing.
Step #3: 3-Point Qualitative Checklist – Corporate Actions, Dominant Assets & Trustworthiness
Point #1: Check for Corporate Actions
Since an Annual Report is merely a “snapshot” of the company’s financials, things can change rapidly. Nico Steel’s report was published in June. The accounting was done and accurate up till February. You might have only chanced upon it in October.
That time difference might mean drastic changes to the business. So look out for corporate actions that the company will have to disclose under the Singapore Exchange. You can also use this website.
Most of the time, there will be nothing major to take into account.
But you should be on the alert for company actions that can alter your calculations. For example, share buybacks, share splits, disposal of assets, etc.
Point #2: What Assets Are You Buying?
When you look at the company’s financial statements, you must assess it for the assets you are purchasing. As described in the CNAV section, we take into account the assets we care about.
The next step is to verify that they exist and to check how much all of is worth. We generally discount 50% off income generating assets which are not as reliable as Good Assets in terms of value.
Note that in Nico Steel’s case, its share price was still below that of the CNAV score even without taking into account the inventories it had.
We also want to watch out for assets that might be depreciating very quickly such as food produce and or inventories that might be outdated by industry standards.
Example: Would you want to own the inventory of a company with $2 million in floppy disks? In 2019?
I hope your answer was no.
Point #3: Establish Trustworthiness – Skin in the Game, Honesty, Accuracy
Our calculations of the company’s net worth is based on its numbers in the annual report.
The accuracy of a company’s annual report is based on its honesty.
Accordingly, we have some important questions to ask.
Did the company financially engineer its books? Is the management open and honest? Can they be relied upon to not “cook” their books?
An easy way to bypass such subjective questions is to look at whether management owns the majority of the shares in the company.
If the Chairman or the CEO of a company owns more than 50% of shares in the company, but not more than 70% (we don’t want them to have too much power), their interests will be more aligned with the shareholders. If they do own close to 50% of the company, they are unlikely to take actions to harm their own wealth.
In Nico Steel’s case, the ownership disclosed by the annual report looks like this:
As can be seen, insiders of the company owned a majority of the shareholder-ship.Nico Steel passed the test of our CNAV rule-based process.
It was under-valued. Its share price traded at low multiples of its net asset valuation. There was significant potential profit that would be well worth our time.
While unprofitable for a short time, it had the cash to sustain operations and it was not buried under a mountain of debt.
Management had no pertinent red flags to be raised, and its shareholder-ship indicated shareholder interest alignment.
Terence bought the stock in 2017 subsequently at $0.004.
Price Plunges 50% to $0.002, What Did Terence Do?
Terence did the tests. Terence performed the checks.
He knew it was a good buy – a great buy even.
After Terence pulled the trigger and bought the shares,Nico Steel’s share price plunged 50% down to $0.002.
How would you react? Will you sell in a panic? Will you pray to your god?
Logic is a strange and funny thing in the landscape of emotion.
Emotionally, as investors, your first reaction might well have been to pull out of the stock.
The ones who think a little more might have held onto it.
How many of you would have bought more of it?
Terence did. When viewed emotionally, this is an insane, even suicidal move. After all, he did just lose half his investment.
Logically, however, this was a different story.
Logically, Terence did the tests. Logically, he knows it’s a great buy.
So when the markets depressed the prices of Nicol Steel even further, Terence saw it for what it was.
An opportunity to gain even greater returns.
In fact, when the market prices shifted down by 50%, Terence calculated and saw that the fundamentals of the company had not deteriorated by a lot. It’s fair value had not shifted so much that it justified the plunge in price.
All the market had done in signalling their lack of confidence was allow him an even greater discount on his original investment!
The market had handed him a gift!
Had he reacted emotionally, and had he lacked a proper framework to know why and how he was invested, he would have pulled out in fear when the price of Nico Steel plunged and lost 50% of his investment!
In following the framework, in understanding the fundamentals, Terence was able to react with logic rather than emotion – and reaped a neat gain of 250%!
Was Terence Just Lucky?
I don’t quite know what to say to that. There will always be critics and naysayers who will claim its all luck.
To be fair, I cannot claim that luck was not in play at all.
Certainly, if the movements of stocks could be mapped out, then the world would be filled with more rich people. But that is not the case.
Yet, we cannot accept the statement that it was entirely based on luck.
After all, its not like we lined up stocks on a roulette wheel and threw darts at it to determine our investment. That would really have been luck.
We cannot guarantee that all of our stocks will perform as well as Nico Steel has. No one can do that.
What we do know is that we have the statistical probability of outperforming the market over time using Factor Investing framework. Just as Terence has. The above case study is just one of the many examples.
If believe in investing with a clear and methodical process, armed with a statistical advantage, click here to join our upcoming Factor Investing intro-course.
Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.