Who doesn’t want to buy something which is good and cheap? Don’t you?

But what is “good”? And how do you know if it is “cheap”?

Don’t you want to buy a 2020 Lexus LS for just RM50,000? And won’t you want to buy 1,000 shares of Nestle for RM2,000?

That is precisely what this article is about – buying good stocks at a cheap price. That is the ultimate success of stock investing.

How to define ‘good’ companies?

A good company is one that provides a high return of capital.

Consider this: RM100 of additional capital created by Business A employing RM200 of capital, is more impressive than Business B employing RM1,000 and getting a return of RM300.

Return on investment, ROI (A) = 100/200 = 50%
ROI (B) = 300/1000 = 30%

One major metric is the return on equity (ROE). However, this metric can be and is often clouded by the capital structure, one-time-off items etc.

For example, a highly leveraged company can have a high ROE during the boom stage of the economy, but suffer huge losses and face a high bankruptcy risk in times of economic crisis.

A one-time-off gain item skewed the return and is hence not representative.

Hence, it is preferable to use the return on invested capital (ROIC) where all capital contributors are taken into account, and resources not utilised in the ordinary operations such as excess cash excluded. It also excludes those one-time off items.

ROIC should be higher than the costs of capitals in order to provide shareholders with wealth maximising.

Return on Capital (Modified ROIC) = EBIT / (Fixed Assets + Net Working Capital)
where EBIT is earnings before interest and tax, or operating income.

Other complementary attributes of a good company are high growth, good cash flows and free cash flow to ensure quality earnings, and a healthy balance sheet as a prudent risk management.

A high growth company will increase its earnings in a fast manner and hence the share price.

Without good cash flows, a company will have to continue to borrow money for preservation of its business, business expansion, buying back shares or distributing dividends.

Qualitative attributes of a company such as a credible management and good corporate governance would come in handy too.

Now that you know what a good company is, exactly what price are you willing to pay for its stock?

Defining value

Research has shown that investing in good companies is not necessarily a winning strategy. This is because generally the market has built into it these expectations.

The biggest danger is that the firm will lose its lustre over time when the high expectations are not realised and the premium paid dissipates.

A simple metric used to carry out “buying things well” is to compute the price-earnings ratio (PE) of a stock.

A low PE, say of less than 10, may signify that the stock is cheap. However, this metric suffers the same fate as in the computation of ROE above, the unstable and manipulative R, or net profit in the bottom-line of the income statement.

Besides, different times, industries, different growth profiles, health of balance sheet etc will result in completely different PE ratios.

Hence, a better metric as in the above is the use of enterprise value (EV) against the earnings before interest and tax (Ebit) to take into account all capital providers but excluding non-operating cash or cash equivalents.

Earnings Yield = EBIT / Enterprise Value

A low EV/Ebit, or a high earnings yield (Ebit/EV) of more than say 15%, may signify the stock is selling cheaply and vise versa.

Other market valuation methods are enterprise value-to-sales, price-to-book, price-to-cash flow, price-earnings-growth (PEG) etc.

All the above are only valuations in relative terms. The best is if one can estimate the intrinsic value of the stock well and then invest in the company with a wide margin of safety. That involves the controversial discount cash flows analysis.

Why does this still work in Bursa?

Since buying good stuff cheap is the logical thing to do and it is intuitive, why does it still work and how is this advantage not arbitraged away in a supposedly efficient market?

One major reason is the emotional biases inherent in all investors.

Only a few participants in the stock market are interested in dull stocks with not much trading activities. There is no fun watching it with little or no movement in share prices.

They are also subject to the detrimental investing behaviour of fear and greed, selling stocks cheaply when in a panic, and buying high when euphoric.

Secondly, there is this institutional imperative.

Fund managers are more concerned about their career risks in following a winning strategy if it involves enduring long stretches of relative underperformance which does happen in the short term, but usually not in the long term.

They feel that it is safer to be wrong when everyone else is losing money than to be wrong when everyone else is making money which the formula can do.

So, are you ready to utilise this winning strategy, buying good stuff cheap, in Bursa as well as in the international market to build up your long-term wealth?

This article first appeared in MyPF. Follow MyPF to simplify and grow your personal finances on Facebook and Instagram.