Taken from http://www.bigfatpurse.com/2010/07/your-first-1000000-making-it-in-stocks-by-dr-michael-leong/
Dr Michael Leong is mostly known as the founder of
ShareInvestor. He is also a successful stock investor and in his first book, “You First $1,000,000 Making It In Stocks”, he shares his investing philosophy and methods.
A Fundamental Analyst and Value Investor
Primarily, he uses fundamental analysis for stock investment, while at times, he uses “tikam strategy” to play speculative stocks. He opined that fundamental investing is more risky than short term trading, as long as the latter has an exit system to cut losses below 10%. However, he believed fundamental investing is where most money is made as the returns can be several times the capital outlay. At times, the lure of short term trading does seem irresistable, and he says, “I set aside money for fundamental investing and also some money for speculating. The money for speculating keeps my adrenaline flowing, but I know that I am not going to be financially independent just by speculating. Having speculative money also prevents me from itching to interfere with my longer-term fundamental counters.”
Most of the homework is done prior to buying a stock. He spends a lot of time researching and only holds 5 good fundamental stocks. When he buys a stock, he sets a price objective where he will exit to prevent himself from getting greedy and get caught in euphoria. If the fundamentals changed, he would exit too, even with a loss. On the other hand, if the fundamentals remain sound and if the market corrects, he may even average down the stock.
What to look out for in a stock?
A company has to efficiently deploy excess capital - Buying a business that is outside the core competency of the company is undesirable. Buying back shares is better but it is not sustainable, as the demand is supported by the company itself. The best is when the company can invest in it’s own business and grow future profits. If the company cannot find a better use for the excess capital, he prefers the company to distribute them to shareholders. This is on the premise that shareholders know best how to allocate the money.
Look for companies with higher profit margin and not higher revenue - A $10 million company having a profit of $1 million yields a 10% margin. A $100 million company earning $2 million of profits yield only 2% margin. Hence, in difficult times, the company with the bigger margin can withstand a drop in profits better than one with a smaller margin.
Look for “free” business – Buy stocks that have more net cash in their bank than their market capitalisation. “This means that for every dollar that I invest in these stocks, the company must have at least a dollar in the bank and ideally, the company does not have any borrowings. This also means that the business of the company comes to me as the investor for free. My next assessment is whether this ‘free’ business is sound and is not bleeding too much cash. To do that, I look at the company’s cashflow statement. I am fine if the company declares large losses, so long as these losses are non-cash related. The key is to find ‘free’ businesses that will survive the downturn, so that when the economy turns around, these businesses can regain their former enviable positions during good times.” “Firstly, I much prefer companies that keep their cash in a Singapore bank, as I have more trust in the banking system here. Secondly, cash to me comprises real cash and fixed deposits only. I don’t believe in cash equivalents as this can mean many things, including bonds.”
Low liquidity is good news – A trader should look for shares with good volume, so that he can liquidate when needed. On the contrary, an investor should look for undiscovered gems, and not attractive to many buyers. They are likely to be undervalued as the demand is not high. As he said, “If I am right in my judgement and the stock does well, other investors will climb in later and will create the liquidity to allow me to liquidate my positions.”
Seek capital appreciation, not dividends – “I do not put too much value on dividends when I look at a company, unless of course, the company has a monopoly or has such a strong brand name that they can increase their pricing without affecting the demand.” “It is capital appreciation that is much more important to me than dividends when I invest in shares.”
Margin of Safety – The concept of Margin of Safety is initiated by Benjamin Graham. Most people who practised it use discounted cashflow projections, and forecast 10 years in advance. However, Dr Michael reckoned that given the dynamic nature of businesses, it is even difficult to forecast cashflow of a business for a following year. He uses Net Tangible Assets (NTA) as a measurement yardstick. He defines NTA = cash + Singapore properties, and prefers stocks in a company whose market capitalisation is less than NTA. In this way, the existing business is as good as free to the investor. This is the margin of safety that he looks out for. He will also visit the properties.
What to do when market cycles change?
Spot megatrend to buy low and sell high – “A megatrend is a trend of the general market that could last for years. One example is the bullish megatrend that started in early 2003 and ended in late 2007. In between these periods, there were a number of mini-trends, which can go up or dowwn daily, weekly or even monthly. Fundamental investors are mainly interested in the megatrends.” Investors must be able to spot megatrends; buying during a dip or correction, and selling when market becomes euphoric or hit exit price. An investor has to be patient and hold onto the winners during the bull run.
Keep some cash for opportunities – “In the event that I cannot find any company with good fundamentals, I will be just as happy sitting on cash and waiting for the next downturn. The market opportunities will always be there if you have money.” “When the market is bearish, I keep on accumulating for my fundamental stocks. As always, I know that my timing is never good. Hence, I have a habit of collecting stocks slowly and I always make sure that I set aside enough funds to keep collecting over a long period of time. As such, I am seldom fully vested in terms of fundamental stocks.”
Use warrants for hedging – Dr Michael uses warrants to hedge against his shares, when he anticipates a market correction. However, it may become a crash and as an insurance he will buy deep out-of-the money warrants, which in this case, he will only gain when the market collapses. Otherwise, the warrants will expire worthless. In fact, he hopes for the latter.
Specifically for IPO stocks
“With IPO stocks, the major shareholders are usually under moratorium for 6 months to a year, meaning that they will not be able to sell their shares during these post-IPO periods. As a result, the free float during these periods will be limited to the number of IPO shares offered for sale. In many cases, this will amount to just 20% of the total number of shares. As supply is limited during these 6 months to a year, the post-IPO stock price can rise sharply if demand is high. But when the moratorium is over, there will be a lot more potential supply of shares, as the major shareholders can then sell theirs. This is the reason why most IPO shares perform well only in the first few weeks of trading, only to fall back to their IPO prices within 6 months of their launch.”
Word of advice
“Investing successfully requires a combination of experience and foresight. It is very tough to get all these experiences when you are young. I always encourage those who want to be successful in the market to excel in what they are currently doing first, as every occupation teaches you something in the university of life. Thereafter, they should try their hand at running businesses. Only after that should they consider investing as a career, as I don’t think you could learn life’s experiences by clicking your mouse and clacking on your keyboard.”
“Wealth will come when you have the experience. Experience only comes when you work on the job. Reading does not, and will not, imbue you with experience. However, there will always be the young who think they are special and know it all. They will be the first causalties in any stock market correction or crash.”
“If you seek financial freedom, you have to put to risk a large chunk of your capital. To reduce the risk on this capital, you have to do your homework and believe in yourself and your selection of stocks.”
Observe not only is the equity line smoother, but the average return to this strategy is also more than twice that of the one on the Mainboard. Annualizing these returns would indicate that one could get a market-neutral >90% profit every year, unleveraged. The annual risk (stdev) from this strategy would only be ~5%, so the return would be much higher if this strategy was scaled up to the same risk as the market.
Observe not only is the equity line smoother, but the average return to this strategy is also more than twice that of the one on the Mainboard. Annualizing these returns would indicate that one could get a market-neutral >90% profit every year, unleveraged. The annual risk (stdev) from this strategy would only be ~5%, so the return would be much higher if this strategy was scaled up to the same risk as the market.
