Devil lies in the details

Devil always lies in the details. Recently, the IPO of BaWang International (Group) Holding Limited (1338) becomes very "hot" in the stock market. When you look through the propectus of this company, you will find that this company is carefully packaged to give a good image to the public which is common for new IPOs. In the past, we have discussed how to read through the propectus in evaluating IPO. Bawang now gives us one typical example why we say "Devil lies in the details".

When we turn to page 7 of the propectus of Bawang, we have the "Consolidated Balance Sheet" with :

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,441 102,830 298,148

Of which the three figues represents the cash and cash equivalents up to 31st Dec of 2006, 2007 and 2008 respectively. Wow, the company has a cash and cash equivalent of 298,148,000 before 2009. You may start to think that how generous it is for Bawang's boss to leave such cash in the company before IPO. Oh, wait a moment. Devil lies in the details. When you turn to page 8 of its prospectus, you will find the following paragraph :

"Our Company declared to our sole shareholder, Fortune Station, two dividends of HK$166.7 million and HK$116.7 million on 7 January 2009 and 23 May 2009,respectively, based on the distributable profits at the end of 2008, and the same were paid in January 2009 and May 2009, respectively. For the avoidance of doubt, the holders of Offer Shares will not beentitled to any of the aforesaid pre-IPO dividends."

Oh, that's where the truth is. After the two dividends, the cash and cash equivalents has dropped to HK$14.748 million excluding the cash flow in the period between 1st Jan 2009 to 23rd May 2009. This looks more likely to a general behavior of IPO. Bawang's boss is no special to the others.

Correlation between Hang Seng Index and Other Indices

After my last post of correlation between VIX and some major indices, many of my blog readers show great interest in the topic. In this post, I will study the correlation between Hang Seng Index (HSI) and other major indices. As a common sense, the most influential indices to Hang Seng Index should be indices of US stock market and indices of China stock market. In such case, I have selected S&P500, NASDAQ (NQ) , SSE Composite Index (SHC) and Hang Seng Chinese Enterprise Index (HHI) as a reference for the correlation study. The correlation coefficients between HSI with these four indices are calculated based on the daily close of each index from 3rd Jan, 2005 to 31st Oct, 2008. The results are as below :

1. S&P500 with HSI : 0.76

2. NQ with HSI : 0.82

3. HHI with HSI : 0.99

4. SHC with HSI : 0.93

My Findngs :

1. SHC has a higher correlation with HSI than S&P500 and NQ which reflects the fact that more and more chinese enterprises are selected as components of HSI and the chinese economy is now more influential to the economy of Hong Kong.

2. To my surprise, NQ is more correlated to HSI that S&P500. The reason behind may be quite interesting to study.

3. The correlation between HHI and HSI is very high which is very predictable as these two indices are in the same stock market and share some common components.

Some poeple may raise the question : "How about the US stock market and Chinese stock market?" I also calculated the correlation coefficient between S&P500 and SHC. The result is positive with a correlation coefficient of 0.76.

Correlation between VIX, Dow, S&P500, Yield

Recently the market becomes more and more volatile. Many people turn to VIX to see if there is any indication in the future trend of stock market. VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. it represents one measure of the market's expectation of volatility over the next 30 day period. Generally, VIX is referred to as Fear Index which shows whether the market "fears" about the future. When VIX is high, the more "fears" the market is.

In order to have a more scientific view on the relationship bewteen VIX and common market indices, I have done an analysis between VIX and Dow (Dow Jones Industrial Average Index), S&P500 and 10 Year Treasury Notes Yield. The analysis is to calculate the Correlation Coefficient* of VIX to the other three to see how these more indices or figures are correlated. Five year data (daily close from 31 Oct 2003 to 31 Oct 2008) are taken in this analysis.

Below is the result of calculation :

Correlation between VIX , dow and 10 Year Treasure Notes Yield :

VIX & Dow : -0.02577

VIX & SP500 : -0.15889

VIX & 10 Year Treasury Notes Yield : -0.44814

Analysis of result :

1. All three are negatively correlated with VIX which means when VIX goes higher, Dow, S&P500 and Yield will goes lower. This is very close to our general thoughts. When the market has more "fears", the stock market will goes lower as people are more likely to sell their securities. On the other hand, more people will buy treasury notes which drives the yield lower.

2. On the level of correlation, S&P500 has a higher correlation than Dow which is also expected as VIX is the IV of S&P500 in the coming 30 days. However, it is a surprise that the correlation between Dow and VIX is close to zero which means they are almost non-correlated. Therefore, we should NOT use VIX to indicate the trend of Dow. S&P500 represents a broader market and the indication to its trend from VIX is more effective. However, the correlation for these both is rather low.

3. The correlation of 10 Year Treasury Notes Yield is the highest among the three. More people will park their money to the relatively safer Treasury Notes when they feel more fears. When VIX is higher, the Treasury Notes Yield is more likely to be lower.

Conclusion :

From the above analysis, we can see that VIX is not a very effective indicator of Stock Market but more indicative to Treasury Notes Yield. Higher VIX will drive a lower yield.

*Correlation coefficient is measure of linear association between two variables X and Y. The coefficient lies from -1 to 1. Correlation coefficient -1 means the set of data are negatively correlated and 1 means positively correlated. 0 means non-correlated.

Warren Buffett's Latest Essay on New York Times

Undoubtedly, Warren Buffet is the best practitioner in Value Investing by now. In his latest essay "Buy American. I am" dated 16th October, 2008 for The New York Times. He outlined the basic and most essential ideas of Value Investing. Below are some of the major points abstracted from his essay :

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

If you want to have a full idea of his essay, you may click the following links for full details :

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=2&ref=opinion&oref=slogin&oref=slogin

Take a look. You will be most benefited.

Warren Buffett Comments on China

Recently, Warren Buffett mentioned in an interview on CNBC that he has tried to bid on one Chinese stock but was not accepted. This has become a very hot topic in Hong Kong media and everyone is interested in finding which stock it is. But very few people are interested in what Warren Buffett has told CNBC in the interview. Actually Mr Buffett also talked about his view on China economy and its future which is very meaningful for us. The name of the program is :

"THREE HOURS WITH WARREN BUFFETT - LIVE FROM OMAHA" ON CNBC'S SQUAWK BOX WITH BECKY QUICK, FRIDAY, AUGUST 22, 2008.

You may find the full part of his interview on CNBC.com (http://www.cnbc.com/id/19206666/). For those who are interested in his view on China, you should pay attention to TRANSCRIPT/VIDEO PART ONE and TRANSCRIPT/VIDEO PART SIX. Mr Buffet has told Becky about China that "But it's a terrific--it's going to be a terrific area for business. So, under the right circumstances, you could see us with a lot of money there."

It seems that Mr Buffett is very optimistic about China's Economy and its future!

Stock market as weighing machine

Facing the recent fluctuations in stock markets around the world, many investors were heavily affected. Very few people can really ignore the price fluctuations of stocks. This is really a good test for a value investor. One article from Warren Buffet may help us in facing such situation. In 1978, he wrote an article noting that the Dow had dropped 20 percent in the prior six years, book value had risen 40 percent, and these stocks were earning about 13 percent on book value. The Dow was trading at or below book value for parts of 1979. On 21st December 2001, Warren Buffet wrote another article in Fortune to respond to his previous article. Some of the contents are abstracted as below :

"At the time of the [1978] article, long-term corporate bonds were yielding about 9.5 percent. So I asked the seemingly obvious question : "Can better results be obtained, over 20 years, from a group of 9.5 percent bonds of leading American companies maturing in 1999 than from a group of Dow-type equities purchased, in aggregate, around book value and likely to earn, in aggregate, about 13 percent on that book value?" The question answered itself." "Now, if you had read the article in 1979, you would have suffered - oh, how you would have suffered! - for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." "But I think it is very easy to see what is likely to happen over the long term. Ben Graham to us why : "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale."

Let's don't forget the famous sentence :

"Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run."

Bull's Eye Investing

Recently, Mr Cho (曹仁超) of Hong Kong Economic Journal (信報) - a highly respected investor in Hong Kong - has highly recommended Bull's Eye Investing Strategy as the right investment strategy for the present and coming stock market which should be more appropriate that the long adopted Buy-and-Hold strategy.

The Bull's Eye Investing Strategy was proposed by John Mauldin in his book "Bull's Eye Investing - Targeting Real Returns in a Smoke and Mirrors Market" published in 2004. In his book, he has illustrated a lot of statistics from differnt aspects to suggest that the coming 20 or more years will be a secular bear market. In this period, the performance of stock market will be similar to the period of Dow Jones performance from 1964 to 1981 within which the Dow Jones Index just moved within a range and posed a gain of around one-tenth of 1 percent though the GDP actually grew 373 percent. Therefore, he has pointed out that investors should focus on absolute return instead of relative return and adopted the Bull's Eye Investing Strategy.

Then what exactly Bull's Eye Investing Strategy is? In page 262 of his book, John has summarized this strategy with a few words as below :

"The essence of Bull's Eye Investing is quite simple. Target your investments to where the market is going, not to where it has been. Steady, stable, sure. Buying something that is undervalued, perhaps grossly undervalued, and waiting for the value to be seen by others is the way to real returns. Buying what everyone else is buying, after it has already risen in value, is why most investors simply do poorly"

To me, Bull's Eye Investing is simply another form of value investing. The key is still buy something which is undervalued. However, should we stick with the Buy-and-Hold strategy? In this issue, I have a different view from Mr Cho with the following reasons :

1. John's book is mainly focused on US stock market for which the future performance will be different from Hong Kong and China stock market. Even John himself also suggested investors to diversify their investments in other market other that US market. To me, the future of Hong Kong stock market should be on the Chinese enterprises which have a bright future of development. The China enconomy is now similar to the Hong Kong enconomy in the 70's and great development and change is expected to come. Buy-and-Hold strategy will be very suitable for this kind of market. We have already had many examples in Hong Kong that even a general citizen can accumulate huge amount of wealth from 70's up to now with this strategy.

2. Value investing is more focused on selecting the right company to invest. As Warren Buffet has said, you should treat yourself as one of the owner when you buy the shares of a company and prosper together with its future development. Simply focus on overall performance of stock market is not the key to value investment. Buy-and-Hold also does not mean you buy the stock and hold it. You have to do your own analysis and buy the stock when it is undervalued. Therefore Buy-and Hold strategy should still be the right strategy for value investing in any form of market.

Hong Kong Stock Market - From A PE Perspective

Traditionally, PE ratio is a useful measure of the valuation of a company. Recently investors have been diverted to other means of measures such as PEG, PB ratio and ROA etc such that the high valuation of stocks in the past few years can be explained in a more reasonable manner. However, the importance of PE in evaluating the stock market should not be ignored. PE ratio gives the meaning of the number of years you can earn back your investment (the price you paid) given that the earning does not change for the given years. In reverse, the PE gives the earning yield such that investors can compare the yield with other type of investments to see if such investment is worth.

How is the application of PE in evaluating Hong Kong stock market? I have plotted a graph of monthly PE of Hang Seng Index (a widely adopted indicative index for Hong Kong stock market) for the period of Jun 1974 ~ Jun 2008 which is shown at the top of this blog. From the above graph and data, I have the following findings which may be useful in formulating investment strategy for Hong Kong stock market :

a. The average PE over the period is 14.58 with a Standard Deviation of 3.6. This means 68.27% of the data points lies within PE ratio from 10.98 to 18.18 (1 SD). 90% of data points lie within PE ratio from 8.68 to 20.48 (1.645 SD). This gives us a hint that whenever the monthly PE of HSI goes beyond 20.48, it is more likely that the market is overvalued and there is 90% chance the market will turn downwards. This is the moment of last tango. For those monthly PE of HSI goes below 8.68, it will be a real bargain to buy.

b. The lowest of point of PE for each high-low cycle is becoming higher and higher which means the market is willing to accept a higher PE for HSI in the recent years which may be explained as more and more Chinese enterprises were selected as components of HSI which are mainly growth stocks and investors may be more willing to buy at a higher PE.

c. From a simple glance of the graph, I would rather start buying at around PE ratio of 10 for which the risk has been significantly reduced.

In conclusion, I will suggest investors to buy when HSI dips below PE ratio of 10 and avoid stocks when HSI goes up above PE ratio of 20.5.

As a reference for today (17th July 2008), HSI close at 21735 with a PE ratio of 13.19 which is below the mean by 1.39.

Biased Return On Equity (ROE)

In our previous blog, we have discussed the power of ROE which is a good measurement of efficiency of management in utilization of shareholders' equity. By comparing the ROE of different companies, we can observe which company is managed with better effeciency. However, sometimes ROE can be biased such that the actual situation may not be truly reflected. We have to look into the details to see whether the figure is reasonable.

One example is China Construction Bank (939). In its latest interim report 2007, it states that its annualised ROE have increased from 15.67% to 20.88% which is a significantly improvement. From this figure, it may be good to see that the management has hugely improved its efficiency. However, when you look into details of the ROE (ROE=Return/Shareholders' Equity x 100%), you will find that the great improvement is partially because the Shareholder's Equity has decreased. Shareholder's Equity has decreased by 1.35% from RMB330204Mill at 31th Dec 2006 to RMB325,738Mill at 30th Jun 2007. Obviously, this will not be a good news to the shareholders. An increase in shareholder's equity will be more favorable to shareholders.

From the above, you can see that simply comparing figures is not enough in drawing conclusions about a company. Devils may lie within the details.

Finding Prospectuses for Hong Kong Stocks

One of our blog reader asks about where to find the prospectus of Hong Kong stocks. Here is the way. Normally the prospectus is available online through the websites of stock exchange. For Hong Kong stocks, you may go to the website of Hong Kong Stock Exchange ie http://www.hkex.com.hk/ and follow the following instructions :

For Already Listed Stocks :

Click on the "Investor" section at the left and then click on the link "Current Securities" under Listed Company Information Search. Type the stock code (eg ND Paper is 2689), select a time period that covers its ipo and also select "Prospectuses" at the pull down menu of "Document Type". Finally click the "Search" button. You will find your needed prospectus.

For IPO Stocks :

Click on the "Listing Matters and Listed Companies" section at the left and then click on the link "Main Board - Prospectus" for the latest ipo prospectuses.

Blackstone - Will it Be A Wise Investment?

Private Equity (PE) has been the hottest topic in global financial industry recently. At its center is the IPO of Blackstone Group (NYSE symbol : BX) at the end of June, 2007. It is rather strange that both Forbes and New York Times have issued analysis with negative comments on this PE group after its IPO. Is Blackstone really a poor investment option for investors??? Personally, I don't think so!

The first point which draws my attention to Blackstone is that it has attracted the not yet established China State Investment Company to launch its first ever investment by purchasing its shares with an amount of US$3 billion. With an over-subscription of its IPO shares, it seems that everyone is expecting a great share price performance of the group when listed. However, after its IPO, its share price is really disappointing which are majorly due to the negative comments from the media just after its IPO. But why is the media post such comments just after the IPO which to all will know it will hurt the share price of Blackstone? I may think of some possiblities :

1. The investment of China State Investment may has positive impacts on Blackstone but also have negatives from the political side. Right now the major investment of Chinese foreign reserve is US Government Bond. If it diversifies its investments, who and what will be harmed most? Its successful intial investment may lead to a more diversified profile in this foreign reserve investment. This may also be one of the major reasons why the tax issues have been raised during its IPO which surely have negative impacts on its stock price performance.

2. If Blackstone is a good investment, it will be a good target for institutional investors as well as other central banks. They are more willing to buy its shares at a cheaper price. It is rather strange that media issue such negatives just after the IPO and why not before its IPO as their disclosed information has already been available when Blackstone published its prospectus. Don't they know that such publications will have negative impact on its share prices?

3. Nowadays major investment banks are all getting a close eye on the asset management work from Chinese government. These banks may not want a good performance of Blackstone share price which means a successful investment of China State Investment Company and putting a closer relationship between Blackstone and the Chinese. Such relationship will have an influence in their chances of getting asset management works from China State Investment Company.

All the above are just some thoughts from myself as alternative explanations for the poor performance of Blackstone share price. They may be right and also may be wrong.

However, I still believe Blackstone (BX) is a good investment opportunity for investors. My reasons are as follows :

1. The major incomes of PE company are from asset management and buy-outs. Blackstone will be benefited from its strategic partner, Chinese State Investment Company in both ways :

a) A stake of shares from Chinese Government have paved the way for Blackstone to get asset management works for the Chinese State Investment Company. To a PE company, more assets under management means more profit in the coming future. Chinese government is more willing to make Blackstone more profitable due to the issue of "face". This is also why the Hong Kong Stock market flying high during its 10th anniversary of establishment of HKSAR. The recent decline of Blackstone's share price has led to fierce discussions on the investment strategy of China State Investment Company. Therefore, decision makers of the State Investment company need to find ways to drive up the share price in order to reduce internal pressure. This in turn puts pressure on the Blackstone side. Blackstone will also work harder to raise up its share prices as they also don't want to harm the relationships with the Chinese.

b) Greater chance to do business in China which is one of the fastest growing economy in the world. One of the examples is the closing in of Blackstone on its first direct investment in China, a $400 million stake in state-owned chemical company China National BlueStar Group. There will be less obstacles to get into the major business in China and the take over of state owned enterprise.

2. The tax increase issue may only turn into effect on 2012 which is 5 years away. However, this may not be an issue that really matters as nowadays, it doesn't matter much on locations for financial business. There are a lot of locations with enough supports to become headquarter for a PE company and these cities also welcome huge PE group like Blackstone to come. Additional tax burden may force PE to move out of New York which will in turn hurt the finanicial industry of USA. Many financial institutes have already commented that the strict, rigid and complicated regulations in USA is the major reason for its loss of market share to London. Therefore, politicians may need to think twice before they bring critics into actions.

3. Financial service industry relies hugely on great talents. From the great track record of Blackstone, it shows that the company has been great in getting talents to achieve great results and its business model has been proved to be a great and successful one.

From the above, I truly believe that Blackstone is a good company to invest.

PS. I have turned my thoughts into actions and have bought stocks of Blackstone Group.

Lastest Analysis of KB Laminates (1888) Annual Result

Kingboard Laminates Holdings Ltd (1888) has announced its annual result for 2006 on 28th March, 2007. Let's have a close review of this company to see whether the company has any improvements over the past year. Figures obtained from its result announcements were summarized as below with a comparison with the figures from 2005 :

Summary of key figures in 2006 vs key figures in 2005 :

Revenue : HK$8.47 billion (2006) vs HK$ 6.13 billion (2005) +38%
Profit : HK$1.74 billion (2006) vs HK$1.14 billion (2005) +52.6%
ROE : 30.85%(2006) vs 22.62% (2005) +8.23% (simple subtraction)
Gross Profit : 28.45% (2006) vs 28.22% (2005) Similar
Debt to Equity Ratio : 81.74% vs 162.3% (2005) Dropped
Shareholders Equity : HK$5.64 billion (2006) vs HK$5.05 billion +11.68%
PE (2006) : 13.14
(Based on HK$7.53 closing price on 31/03/2007)

Analysis

1. The overall performance of the company is quite satisfactory as the growth of revenue and profit is 38% and 52.6% respectively. ROE also increases to 30.85% from 22.62% which means the management has made use of shareholders equity quite efficiently.

2. The management is set to increase its production capacity by around 35% in 2007 and right now the production is run at about its full capacity which quite encouraging.

3. Increase in shareholder's equity is not quite good as the increase is only around 11% from which it needs around 9 years to double the existing shareholders equity. The company should be more focused on increasing the shareholders equity.

4. Debt to equity ratio is still quite high though it has been dropped from 162.3% of 2005. Such high ratio is due to a 5-year term loan of HK$2.54 billion in December 2006 after the IPO. Without such loan, the debt to equity ratio of the company is only 36.7% which is much more healthy. The management's action of getting loans after the IPO is clearly to avoid the dilution of share interest of major shareholders for giving up too many shares during the IPO and KB Laminate after IPO is a company which can get loans from the bank more easier. However, such action has increased the debt of the company and in turn increase the risk of the company.

Future Risks
1. Price of Copper is rising quickly recently which will increase the cost pressure of KB Laminates.

2. Demand of laminates slow down a bit during the first quarter of 2007 as stated by its management in its result announcement.

3. High debt to equity ratio increases the risk of investment in the company which is led by the loan decision of the management after the IPO. It is no doubt that the Kingboard Laminate (1888) is a better performed company than Kingboard Chemical Group (148) as we have predicted before. However, if the management continued with the mindset (which is common within many major shareholders of Hong Kong listed comanies) of getting easy money from loans through a better company, the company will be harmed finally. This is also one of the reason why the share price performance of KB Laminate is worse than that of KB Chemical.

Conclusion

KB Laminate's performance in 2006 is good and I still recommend this stock as my recommendation of 2007. Many people have been very disappointed with the share performance of this company and it is time for the management to be more focused on increasing shareholders equity at a higher rate and decrease the high debt to equity ratio in order to maximize the interest of shareholders. As long as these aspects are improved, the share price will reflect the true value of the company.

REMEMBER : PATIENCE IS AN ESSENCE OF INVESTMENT

A Discussion on Strategic Investors of Hong Kong

One of the blog readers has posted the following comment which is quite interesting to discuss :

"Regarding stategic Investors. Both Cheng Yu Tung (New World) and Thomas Lau have "Interesting" histories and not always friendly to minority shareholders. Care to comment?"

My response is as follows :

Many people may have bad experiences in investing in the companies owned by these two people. The major problem is that many major shareholders of listed companies in Hong Kong have treated these companies as a way to gain money from but not sharing the profits with majority shareholders. The most profitable part is still hold in their own hands. For example, Chai Tai Fook is the most profitable company of Mr Cheng which is privately owned and New World Development (0017) is a listed company but with high level of debts. For profitable projects or investments, Mr Cheng will invest with Chai Tai Fook instead of New World. This is a typical example of common thoughts of Hong Kong rich people not just Mr Cheng. Even Mr Lee Shau Kee who is recently treated as Warren Buffet of Hong Kong is investing with his own investment flagship but not his listed company Henderson Land (0012) . Therefore, when considering the roles of strategic investors, we need to identity by what means these people are investing in the new companies. If they are not the major shareholders but simply strategic investors, it should be a good news to minority shareholders like us as we do not have to worry about any "capital tricks" and instead they can act in a positive way for us to push a good performance from the new company just like TCI 's role in the Link Reits (0823). However, in the case of Kingboard Laminates (1888), there is no confirmed information up to now that they actually have invested in this company.

In some forums, I have read that some people invested in Kingboad Laminates simply because they think that Mr Lau will drive the share price up. These thoughts are very dangerous. We have to remember profit is the final driving force of share price not strategic investors!

2007 Hong Kong Stock Recommendation - Kingboard Laminates Holdings Ltd (1888)

Kingboard Laminates Holdings Ltd (1888)

Background :
Kingboard Laminates Holdings Ltd is a subsidiary spinned off from Kingboard Chemical Group (148) which focuses in manufacture and sales of laminates and upstream component materials.

1. Is the industry has a growing demand? What is the relationship between demand and supply in the industry?
Ans : The demand for laminates is driven by the demand for PCB. The global laminates market was estimated to have a growth rate of 6~8% in the coming 2 years. The growth rate of China laminates market is around 20~30% in the past 3 years. This means the industry is still in a growing state. With the launch of Microsoft Vista and 3G in China, the demand for PCB is expected to increase in the coming years which in turn will increase the demand for laminates. Kingboard was rated no 1 in 2005 with 9.9% market share in global market and 31.7% in China market. With the large scale of economy, the company can achieve the cost competitive advantage stated by Michael Porter and gain greater market share in the future. In its growth to a larger capacity, it also creates greater barrier for new competitors to enter this industry.

2. Is the company profitable over a period of time and what are their average revenue and profit growth rates?
Ans : The company is profitable for the year 2003~2005 with a profit growth of 158%, 5.8% respectively. The half year result of 2006 has a growth of 58.4% over 2005. The revenue growth for the year 2003~2005 is 56.8% and 31.6% repectively. The company has experienced hard time in 2005 but the growth will continue in the coming future which is reflected in the half year result of it. The gross profit margins from 2003~2005 are maintained in a healthy state with figures of 23.9%, 33.1%, 28.3% respectively. The half year 2006 GP margin is 29.6%.

3. What is the company raising money for? Paying debts? Future development? etc
ANS: 60% of fund raised used for further development of factory production capacity in China. 30% of fund used for paying loans. 10% for working capital.

4. What are the major risk factors when investing in this company?
ANS:
a) The capacity of the company has reached nearly full operation. Its future growth relies on the increase of its capacity.
b) Rise in cost of raw material will damage its profit margin.
c) The tax examptions from Chinese government for some of its subsidiaries will expire in the coming years.
d) Management issues happen to Ocean Grands Chemicals Holdings Ltd may also happen to this company.

5. Are there any odd numbers in their financial statements?
ANS: Not yet find any odd numbers. But the debt rate is high in the past which can be improved after its IPO.

6. Is the IPO price reasonable when compared to its expected profits and dividends? Is it valuable when compared to those companies already get listed?
Ans : The IPO PE is a bit high when compared with other industrial company but it is quite difficult to compare with other companies in the same industry as many of the large competitors in the industry are subsidiaries of large electronics companies for which the results of individual subsidiary is not presented separately. For the dividend, Kingboard is expected to pay not less than 30% of its profits as dividend each year. With the forcast provided by the company for 2006 will not be less than 1623.8 million, the dividend yield will be around 1.95% at minimum. Not very attractive from dividend yield.

7. Find out some key ratios for study such as ROE, ROA, PE, PB, Debt to Equity ratio etc.

Ans:
ROE : 22.62% (2005)
ROA : 8.62% (2005)
PE : 15.4 (estimated 2006 PE based on HK$8.32 closing price on 29/12/2006)
(Assumption : Full 2006 profit : HK$0.54)
Debt to Equity Ratio : 162.3% (2005)
Gross Profit Margin : 29.6% (half year 2006)

As stated before, the debt ratio is quite high before IPO.

8. Any strategic investors? Which investment bank is the underwriter?
Ans : Two rich people in Hong Kong Mr. Cheng Yu Tung and Mr Lau Luen Hung have expressed intersts in buying the IPOs but no further information are disclosed that they have holdings in the company. Goldman Sachs is the underwriter and coordinator which has a good track record in the past.

9. Other Considered Factory

a) The company management have a good track record in managing the parent company of Kingboard Laminates. The chairman has stated the management target for Kingboard laminates is to double its revenues in the coming 5 years and seek proper acquisition opportunites to expand.
b) Kingboard Laminates is the most profitable part of Kingboard Chemical Group, its parent company. Its spin off for one reason is to lower the debt of Kingboard Chemical Group which provides a good opportunity for the market to have a more profitable investment. Spin off of subsidiary is one of the good factor as stated by Peter Lynch in investment.
c) The IPO price is set at HK$7.73 which is around US$1 for which it is clear to set the target for institutional investor holdings.
d) The Kingboard Chemical Group still holds 72.5% of Kingboard Laminates and the shares in the market after over-allocation is 825 million shares representing a market value of hong kong dollar 6.864 billion (calculated based on the closing price of HK$8.32 on 29/12/2006) which is not huge when institutional investors starting to buy its shares. However, the attitude of institutional investors to invest in such small medium enterprise may be affected by the issues happened to Ocean Grand Chemical Holdings Ltd. in 2006.

Conclusion :
After weighing the pros and cons of the company, I still believe that Kingboard Laminates Holdings Ltd (1888) is a company suitable for LONG TERM BUY and HOLD. See if it can be a "tenbagger" in the long run!

Reading Prospectus (con't)

In this section, we will take a newly listed company in Hong Kong Stock Exchange this year as an example for further explanation. We will use those data taken from its prospectus for analysis. This company is :

Nine Dragons Paper (Holdings) Limited (2689) - abbrev : ND Paper

Questions :

1. Is the industry has a growing demand? What is the relationship between demand and supply in the industry?
Ans : Yes, the industry has a growing demand. In the "Industry Overview" section, the company has provided a clear picture of the demand and supply relationship in the industry. The consumption of containerboard has exceeded its domestic consumption in the past five years and this trend is forecasted to continue at least to 2009. Furthermore, the entry barrier is this industry is high as it requires huge capital investment to install new production line. At the moment of IPO, ND Paper is at the highest volume in the country. This has provided them a great advantage. Even an average company can perform well in a growthing industry.

2. Is the company profitable over a period of time and what are their average revenue and profit growth rates?
Ans : In the "Summary" section, you can find that the company has an average revenue and profit growth rates of 46.6% and 65.7%. The profitable trend have continued for the past years. Such growth is exceptionally good.

3. What is the company raising money for? Paying debts? Future development? etc
Ans : You may find the answer in both the "Summary" and "Future Plans and Use of Proceeds" sections. Not more than 55% of capital used for establishing new production lines. Not more than 35% used for paying short term loans and the remaining used as general working capital.

4. What are the major risk factors when investing in this company?
Ans : These information are located in both "Summary" and "Risk factors" sections. Most of them are general statements. However, one point should be noted that the major supply of recovered paper is controlled in the hand of its chairman for which this supplying company is not included in the IPO. This means that the profitability of the listed company is controlled in the hands of its chairman who can earn her own money by adjusting the price of supplying recovered paper. Besides those listed, you should also pay attention to the type of management of this company which gives hints in the "Directors, senior managements and employees". Most of the top management are relatives of its chairman for which a family business may induce problem in its long term development.

5. Are there any odd numbers in their financial statements?
Ans : After reading the "Financial Information" section, it does not show any very odd numbers but the debt ratio of the company is exceptionally high. This may be the reason why they need to issue IPO instead of running as a private company.

6. Is the IPO price reasonable when compared to its expected profits and dividends? Is it valuable when compared to those companies already get listed?
Ans : In the "Summary" section, the company has provided a forecast of expected profit in the past half year. The expected PE is 13.6 if the IPO is set at its highest price. This is quite reasonable when compared with Lee & Man Paper (2314) which was trading at around expected PE ratio of 14 at the time of ND Paper IPO.

7. Find out some key ratios for study such as ROE, ROA, PE, PB, Debt to Equity ratio etc.
Ans : Some of the key ratios are listed below :

ROE : 13.7% (Year 2005)
ROA : 2.7% (Year 2005)
PE : 13.6 (expected)
Gearing Ratio : 53.4%
Net Borrowings to Equity Ratio : 212.7%

From the above, it is clear that the company is not operating in a highly effective way and has a high debt ratio. But the growing industry and IPO may improve these figures in the future.

8. Any strategic investors? Which investment bank is the underwriter?
Ans : The strategic investors are listed is "The Corporate Investors" section. There are three corporate investors including Ample Glory Limited (Mr Kuok Hock Nien), Chow Tai Fuk Nominee Limited (Dr Cheng Yu Tung) and Bestfull Limited (Dr Lee Shau Kee). They are solely investors but not involve in the company's management and Dr Lee has a good track record as being a strategic investor. The coordinator and underwriter of ND paper are BNP Paribas Peregrine and Merill Lynch which also give good track record in IPOs.

From the above, the analysis of ND paper is positive in IPO and this also explains why this company has a huge gain after its IPO.

Remember : Even an average company can perform well in a growthing industry.

Reading Prospectus

One of our reader has raised a question about which key factors of the listed prospectus of IPOs investors should pay attention to. I have to admit that with so many Chinese companies get listed in Hong Kong Stock Exchange, it is quite difficult for investors to study all thoroughly. However, I would like to stress on the point that investment is not an easy task. Remember earning money is very difficult and losing money is very easy. Therefore, investors should at least have a basic idea of the company before investing money in it.

In actual sitautions, it is very difficult to use one single method to analyse different companies because different companies and industries have their own characteristics. Anyway, I would like to share some brief reading skills of prospectus here. Normally a standard prospectus should consist of the following sections :

1. Expected Timetable

2. Summary

3. Risk Factors

4. Corporate Information

5. Industry Overview

6. Future Plans and Use of Proceeds

7. Financial Information including accountants' report and detailed financial statements.

If you have limited time, the most important section you should look at is the "Summary" section. In this section, the company will give a brief introduction of the other sections of the prospectus such as risk factors, industry and company overview and consolidated financial statements. With these information, you can have a brief idea of what the company are doing and performing. Furthermore, while you are reading the summary information, you may have further questions which you would like the company to answer. Generally, these questions can be answered in the following sections of the prospectus and you can just flip to the related section to find the answer. For example, you may find the expenses of certain category has dropped significantly before getting listed. You can flip to the "Financial Information" section which is well indexed for different expenses and you can find it out for yourself. In this way, you can read the prospectus more effectively and efficiently.

Normally, I will have certain questions to be answered before reading a prospectus and these questions help me to analysis whether the IPO is valuable to be invested :

1. Is the industry has a growing demand? What is the relationship between demand and supply in the industry?

2. Is the company profitable over a period of time and what are their average revenue and profit growth rates?

3. What is the company raising money for? Paying debts? Future development? etc

4. What are the major risk factors when investing in this company?

5. Are there any odd numbers in their financial statements?

6. Is the IPO price reasonable when compared to its expected profits and dividends? Is it valuable when compared to those companies already get listed?

7. Find out some key ratios for study such as ROE, ROA, PE, PB, Debt to Equity ratio etc.

8. Any strategic investors? Which investment bank is the underwriter?

If you can answer all the above questions, you will have a thorough idea of whether to invest in the IPO or not.

In the coming blogs, I will give some real examples for further explanations.

Business Ethic

Business ethic is an important concept that value investing relies on. Value investing relies on the integrity of management of the company to provide accurate financial and company information for evaluation. The basic concept of stock market is to separate the authorities of management and investors such that companies can effectively raise fund for their future development. In such system, management of the company acts as an agent of its stakeholders to take up the responsibility in managing the daily operations of a company. Management will release general company information on a regular basis for the evalution of investors. However, in recent years, this system has been challenged by some facts that the management has performed some cheating behaviors in order to get interests from their responsible company. The most famous one is Enron in the US for which many investors even the institutional ones were cheated. In Hong Kong, such cases also happened such as the Ocean Grand Chemicals Holdings Ltd (2880). The chairman has made use of the gaps between Chinese and Hong Kong monitoring authorities to generate fake transactions and exagerate the profits of his company. In general, it seems very difficult for a general investor to identify such cheating behaviors through their publized information. However, if you find a company with the following phenomenons, you should be very careful :

1. The major shareholder of the company is reducing his stake in the company even though the company is continuing its profit growth. This is because in general, the major shareholder should be the one who understands more of the company than the public. If under a profitable situation of the company, they still wish to reduce their stake. It should be a warning signal for all.

2. A company that always creates miracles in profits even when the economy is in a down turn or flattened. The management will either be very outstanding or cheating. You should find it out.

3. Firing its auditor for which may be because the auditor has found some faults in the company's financial statements and does not agree with it.

4. Raising fund for some projects that are not realistic such as some companies in Hong Kong have claimed to buy some mines in China for which the mines are non-existing or with much lower output than claimed.

Usually the stock prices of those companies with cheating management will continue to increase due to exagerated profits. Some people may not be able to resist such attractions and start to buy those stocks. However, you should be aware that you may lose all your investments when the profit bubble is blown up. In Hong Kong, a company which is a component of the Hang Seng Stock Index has some of the above listed phenomenons. If you are unable to understand their business model and how the profits be generated, it is better for you to avoid investing in it.

Remember :

According to Warren Buffet's investing strategy, value investors should invest in companies with excellent track records which also reflects their business ethics records in the long run. In such case, it will be much safer to invest.

Response to Comment on the Analysis of Chinese Banks

Thanks for the comment of an anonymous reader in my blog "Analysis of Chinese Banks Listed in Hong Kong".

The analysis of this blog is a general discussion of the banking industry of China. Agreed that more in-depth discussions needed for better understanding of those Chinese banks.
The reform of Chinese banks has just been started for several years and the historical data for a thorough analysis may not be enough. However, analysis should be based on historical data such that we have a better ground in predicting the future development. CCB had its IPO in Oct 2004 for which its performance in 2005 has mostly truly reflected the actual performance of this bank. I don't agree that the figures are solely for higher IPO valuation.

In the short run, the stock price can be affected by certain reasons such as the market atmosphere, demand and supply of stock during the time period etc. BoComm receives higher multiples in the stock market may be due to the following reasons :
1. HSBC as a strategic investor of BoComm has hold nearly 20% of its stock for which the supply in the market is more limited.
2. HK investors are very familiar with HSBC and trusted its management ability in partnering BoComm but not solely for BoComm's own management.
3. Beliefs that smaller companies may generate better growth in future.
However, the stock price in long run should reflect the effeciency and profitability of a company. 1~2 year does not mean too much in investment. Large size companies in banking industry in the long run should be able to outperform smaller size ones as banking is a capital intensive industry. Of course we need to make sure that the bank is well managed. CCB also has a strategic partner of Bank of America and BOA has also sent a team of personnel to CCB to help to improve their management but this is seldom mentioned by the media. Therefore, I believe that CCB will be able to improve their management to achieve better success.

NPL provision coverage is a good idea to be investigated. The NPL of Chinese banks has now been amplified by the market for which has become the major concern of investors. However, if you believe that the economy of China will continue with its rapid growth, NPL should not be a major barrier in investing in Chinese banks. In contrast, this provides a better opportunity for you to buy their stocks at cheaper price.

Economic Franchise

Economic Franchise is an important concept of value investing. A well managed company in a commodity business may not be able to sustain its growth in the long run but an average company with economic franchise can be with good performance for a long period of time. This shows how important economic franchise to a company. There are three characteristics of economic franchise :

1. The product or service are highly needed by its customers.
2. Customers can not find a similar product or replacement easily.
3. Customers of the product or service are not too price concerned.

Companies with economic franchise are more likely to sustain their growth in the long run and their performances in the future are easier to be predicted. Economic franchise can be in different ways of appearances such as branding (Coca-Cola, WD-40), state protected market dominance (Petro China) or market dominance through market (Towngas in Hong Kong) etc.

Branding :
Coca-Cola is a well known brand in soft drinks market throughout the world. Its brand is so well established that even you have got its secret formula, you cannot establish an enterprise with similar performance as Coca-Cola. This is because its brand has been successfully promoted with a representation of modern, tasty and in line with the American/Western culture image.

State protected market dominance
Petroleum is a strategic industry in China and China government will only allow pre-approved enterprise to do business within this area. Petro China is the largest state owned enterprise allowed to do the oil business in China. They can easily dominate the China oil market and turn economic franchise into huge profits.

Market dominance through market
Towngas in Hong Kong has the market dominance in Hong Kong through its management excellence. As an important element in Chinese cooking behavior, towngas have outperform major competitions from petroleum gas and electricity through their well established supply network and excellent service. Their economic franchise is granted by the market ie customers.

In general, market dominance granted by the market is more likely to sustain than state protected as the market not government is the ultimate profit origin in a free market.

Return On Equity (ROE)

After we have found out what the intrinsic value of a company, we can compare the market value of the company with it to see whether the company is value for money. However, value is not the only decisive factor to judge an investment opportunity. One also have to research the company whether it is well managed and run efficiently. One of the figure to reflect this is : Return On Equity (ROE). The calculation is simple :

ROE = (Return / Shareholders' Equity) x 100%

But when working out this ratio, you should be very careful to exclude some one-time factors which may be misleading. For example, the tax exemption from Chinese Government to Chinese banks before their IPOs will lead to a better ROE performance but this ratio will decrease afterwards with the cancellation of such exemptions. From a general idea, you can easily obtain these data from financial websites :

For Hong Kong Stocks : http://finance.yahoo.com.hk

For US Stocks : http://finance.yahoo.com , http://www.etrade.com

ROE is a correct measurement of the performance of the management of a company to show their effectiveness in getting the maximum return from available shareholders' equity. It is better than many other parameters such as Return On Asset (ROA), Earnings Per Share Growth (EPS) because it only takes into account the money invested by investors and truely reflects the return rate generated through these investments.

Warren Buffett is the one who really admire the power of ROE. He also stated that a company with a ROE above 20% can be good as the shareholders' equity will be doubled in 5 years if it can maintain a steady performance in ROE. Below is the ROE of top 5 investments of Berkshire Hathaway owned by Warren Buffett in 2005 :

1. The Coca-Cola Company (KO) : 30.41%

2. American Express Company (AXP) : 25.07%

3. The Procter & Gamble Company (PG) : 21.76%

4. Wells Fargo & Company (WFC) : 19.72%

5. Moody's Corporation (MC) : 185.6%

(Figures obtained from etrade website on 10th September, 2006)

Only one company ie WFC has a ROE slightly lower than 20%. The above figures are only the ROEs of the companies in the past year. In practice, please remember to average the ROEs of a company in the past years to get a steady judgement. Good Luck!

REMEMBER : Invest in a company with a ROE average better than 20% over a number of years will give an amazing return.