Knowing The Market And Companies Well

Foreword from ShareInvestor

This article “Knowing The Market And Companies Well” by Teh Hooi Ling was first published in The Business Times on 05 May 2012 and is reproduced in this blog in its entirety.

It pays to attend AGMs and observe the board’s body language and how it deals with shareholders’ questions

I HAD lunch with a friend earlier this week. He’s a very experienced investment professional, having been a fund manager, a trader and, among other things, helped package equity-linked notes while he was working in London.

He told me how, when he was in London, he actually bought $200,000 worth of Pinnacle Notes sold to him by his broker. But when he went through its prospectus – obtained with much difficulty – and realised what were inside the notes, he wanted out.

After much haggling, he was allowed to sell back the notes at a 2 per cent discount. He begrudgingly accepted. Two years later, following the collapse of Lehman Brothers, some of these notes became almost worthless.

This friend took a break from the highly stressful and sometimes not so ethical finance industry some time back. The inertia to get back into the pressure cooker environment of work life has been too great for him since. Nowadays, he manages his own portfolio.

Over lunch, he shared with me his approach to investing. My friend – let’s call him Mr Tan – invests all his funds for equities in the Singapore market. “This is because I know the market and the companies well.”

There are a few principles that he adheres to. First, good business trumps good governance practices. As long as the company has a good business, some minor lapses in corporate governance is acceptable.

He quoted the example of Apple. Apple has a good business. But it doesn’t have the best of corporate governance practices. The world’s most valuable company has been criticised numerous times before for poor corporate governance. For example in 2010, the California Public Employees’ Retirement System (Calpers) challenged the company’s board election policies and succeeded in changing it.

Prior to that, Apple’s directors could hang on to their seats with a single “yes” vote in uncontested elections. Calpers wanted Apple and other US companies it invests in to adopt rules requiring directors to win a majority of the vote, saying that would make board members more accountable to shareholders.

Initially, Calpers sent in its request to Apple’s board but was rejected. It then submitted an advisory shareholder resolution to force the issue and succeeded in getting the majority of the shareholders to vote for the change.

“For a company in a good business, some lapses in corporate governance is acceptable. But for other companies, corporate governance is of utmost importance,” says Mr Tan.

He adds that he holds only eight to 10 stocks in his portfolio. And he knows companies he invested in very well. He doesn’t do annual forecasts of the companies’ earnings and so forth.

As long as the company is in a positive cash-flow generating business, there is no fundamental change in its competitive advantage and it has a competent and accountable board, he will stay invested.

He makes it a point to attend the annual general meetings (AGMs) of the companies he has invested in. It’s during AGMs, when he tried to pose the difficult questions and observes how the board responds to the questions, that he decides if he wants to remain invested in these companies.

Mr Tan said that, for some companies, after attending the AGMs, he has increased his stakes. But there were five companies from which he exited completely after he came to the conclusion by observing the board’s expressions and answers during the AGMs that they are less than competent or less than honest.

In one, he noticed from the annual reports before the AGM that the company had invested some of its spare cash in equity-linked notes.

So Mr Tan asked the board members what they knew about such notes. Apparently, the answer given was: “Nothing.”

Mr Tan’s follow-up question then was: “What were you investing in these notes if you don’t know anything about them?”

The answer: “We wanted to earn a higher return on our cash.”

Mr Tan: “If you don’t have any use for the cash, we as shareholders would appreciate it if you could return it to us.”

After the AGM, Mr Tan decided that he doesn’t want anything to do with the company anymore. And as it happened, a year later, the company reported a $5 million write-down in its investments in the notes.

One company which Mr Tan was very impressed with after attending its AGM was StarHub. “The board appears very cohesive and their answers suggest that they are on top of their game.”

While Mr Tan likes cash-flow generating businesses, he stays away from real estate investment trusts. The interests of the shareholders and the managers of the reits are not aligned, he noted.

Mr Tan says he will stay invested in the stocks he has picked as long as they still have good businesses. But there are always periods of mispricing, when the overexuberance of investors carried a stock price beyond its fair value. Mr Tan’s technique is such that he limits his exposure to each stock to, say, 8 per cent of his portfolio. When a stock has done so well that its weight in the portfolio balloons to, say, 12 per cent, he will trim his position and bring it down to 8 per cent.

The excess cash may be kept for times of market weakness, or he may deploy the cash to the undervalued stocks in his portfolio.

Meanwhile, Mr Tan also hedges against a bear market by shorting the MSCI Singapore Free Index (SiMSCI) futures contracts. That’s for the protection of his portfolio.

“But one must take a view whether the underlying market is a bull or a bear market. Putting in the hedge during a bull market is very costly and undermines your portfolio’s performance.”

So what is Mr Tan’s view of the market now? Are we in a bull or a bear market. “I believe we are in a bull market.”