Trust the process. Your life won't change in a day, week or month. Be patient. It takes time.

— Anonymous

When it comes to investing, it's simple to say that successful investing is all about finding the right companies (call us Captain Obvious). Yet in reality, the challenge lies in being able to consistently identify great investments and at the same time avoid huge losses. Hence, having the right process is crucial for long-term investors.

Well-known investors in Asia include:

• CHEAH Cheng Hye – Value Partners Group Limited¹
• TENG Ngiek Lian – Target Asset Management Private Limited²
• WONG Kok Hoi – APS Asset Management Private Limited³
• Hugh YOUNG – Aberdeen Asset Management Asia Limited⁴
• TAN Chong Koay – Pheim Asset Management (Asia) Private Limited⁵
• YEO Seng Chong – Yeoman Capital Management Private Limited.⁶

If you do a search on famous investors such as those in this list, you will come to realise that each of them invests with varying strategies, and very often in very different companies too. Nevertheless, all of them are successful in their own right. Why? We believe it is because they stick by a structured investment process that consistently works for them.

Hence a well thought-out investment process is important to ensure our long-term investing success. A sound investment process gives us an advantage of minimising unforced errors. With the compounding nature that comes with investing for the long haul, more money saved leads to exponential returns.

In the next few chapters, we will explore our processes with you, from screening for opportunities all the way to finding out whether the valuation of a company is attractive enough to put our money where our mouth is.

For the first step, we must understand that to find value, we first have to know what we are looking for. We categorise value into three main segments, namely:

1. asset value
2. current earning power value
3. growth value.

These three types of value have also been discussed in many investing books, most notably in Bruce Greenwald's Value Investing: From Graham to Buffett and Beyond. However, we would like to elaborate on these values and how they can be found in the context of the stock markets in Asia. And as a bonus, we have also included a section on special situation investments, which is about spotting arbitrage opportunities in the stock markets.

We set up this book as a practical guide to help you in your Asian investment journey. You could start by reading our book chronologically for a better appreciation of the whole process of investing in Asia. When that is done, you can still refer back to any specific chapter to refresh your memory.

In our final chapter, with the help of real life case studies, we will show you how these approaches play out, taking you through our thought process from start to finish. We will start from screening, to getting the right data, to separating the noise from the important data. And lastly, we will look at how to estimate the value of an investment opportunity, more commonly known as finding the intrinsic value of a company.

Asset Value

Deemed the most important investment book by many value investors, Benjamin Graham and David Dodd's Security Analysis is probably the book that brought value investing to the world. As this book was published in the 1930s (Hint: Great Depression), many of their principles came from finding securities selling below their net asset value. The idea was to buy a company so cheaply that even if the business deteriorated, the investor could still stand to profit from the investment. This is how we can look for the first type of value in a company – asset value.

A popular version of this style is known as “cigar-butt” investing. This came from the idea that if you find a lighted cigar butt lying around on the street, it might be unseemly and dirty, but you can still get a free puff out of it. In the context of investing, you might be looking at companies that may not necessary be well run or have great prospects. But they might be trading at such depressed levels that you can make a profit even if the company winds up the next day.

This meant that even if this company stopped operations, liquidated everything and paid off its debts, you could still get back more than what you paid. However, approaching an asset play does not necessary mean ignoring the dynamics or economics of a company. In fact, understanding how the company works gives us a better appreciation for such companies. Let us illustrate this point with a case study of one of our earlier investments.

Current Earning Power Value

Next, we will be moving on to finding value from a company's current earning power. This is done by appreciating a company based on its current earning power, with not much consideration given to its future growth potential. In short, even without considering any huge future growth, the company should still be attractive as an investment.

Imagine a company priced at $12 per share, with close to no debt and a fairly predictable income stream with earnings of $3 per share. Theoretically, if the company paid out all their earnings as cash dividends, you could break even in less than four years, giving investors a return on capital of 25%. This is without taking into consideration any growth in its current earnings potential. Here is another case study to illustrate how this works.

Growth Value

Our third approach is value through growth. Assessing growth is slightly trickier as we are trying to find value in events that have yet to take place. As no one can forecast the future, you can imagine the difficulty in getting it right all the time in growth investing. Thus, the big risk in growth analysis is in our own expectations and assumptions.

This can be seen time and time again in the market. During the dotcom bubble, any company with any links with the internet, technology or network could be priced at ultra-high valuations (with many not even profitable). This wild expectation was also present before the 2015 Chinese stock market crash. When the A-Share market crashed, it resulted in almost a third of the market value of the A-Shares on the Shanghai Stock Exchange being wiped out.

However, when applied appropriately, this approach can be just as rewarding over the long run. To better understand growth, we are not always talking about high growth. We do not always have to go for companies with sexy double-digit growth rates of 20%, 30% or even 50%. These companies do exist, and if found at the right price, they do have huge investment potential. However, most of the time, their growth might already be priced in and if that growth spurt is unsustainable, your investment might be hit with a double whammy of lower valuations and lower earnings when their growth ends up fading away.

Thus, we must remember that slow growth is still growth. Even companies with sustainable single-digit growth can become one of the pillars of your portfolio. One such company can be found in the realm of consumer staples and today we will be highlighting an easy-to-understand consumer staple with a defensive product range.

In recent years, probably one of the biggest acquisitions in the Asian consumer staple space was when Heineken Holding N.V. took control of Asia Pacific Breweries Limited in 2012.¹⁶ With Asia Pacific Breweries taken off the market, were there any more publicly listed beer companies in Southeast Asia?

Special Situations

Lastly, we have a bonus category for you – finding value through special situations. This opportunity could encompass any of the above three types of value – asset, current earning power and growth. However, the difference is that a company-specific event is required within a short period of time; a catalyst to unlock this unique value. Typically, a special situation investment is more of a short-term investment.

We seek to benefit from special situations, when we believe the market is behaving irrationally about the odds of the event either taking place or not taking place. These events involve corporate action, from the restructuring of a company to mergers, spin-offs, share repurchases, privatisations, bankruptcy, asset sales and even the sale of the entire company.

Narrow Your Search – Screening

So how do we go about finding these possible investments in the ocean of thousands of listed companies?

A good way is by screening. Think of it as a funnel where only the best ideas flow through, enabling us to concentrate on the ones we think have better potential. This allows us to make use of our time more efficiently. At least that's the idea.

Maybe an analogy to shoe shopping would make things clearer. Imagine you are looking to buy a pair of running shoes. If we just go ahead without a plan, we would be looking at the entire universe of shoe stores retailing a whole range of footwear, from slippers all the way to high heels, that are not what we were looking for. Now, what can we do to give ourselves an easier time deciding?

Whether you realise it or not, you have already been screening everyday on a subconscious level. Think about it: by deciding on men's shoes you might have already reduced your options by maybe even more than half. And by deciding on running shoes, you might have filtered out a whole range of other shoes stores selling the likes of leather shoes, loafers, boots, etc. This would dramatically reduce the chances of you walking into Timberland or Hush Puppies store to get running shoes! This then allows you to focus your attention on retailers specialising in running shoes, for example ASICS and New Balance. What we want to do is to translate this subconscious process to the investment universe.

Basically, screening gives us the ability to narrow down our search for a possible investment. Consider a stock market with about 1,000 listed companies. You can do a screen with certain criteria to reduce your search down to a workable number of companies. From there you can then start doing a more detailed analysis on each of them before making an investment. How then do we go about this screening process?

There are countless ways, but screens generally fall in these three categories:

1. Quantitative – for when you have things that can be measured:
   • market cap
   • market price (52-week high, low)
   • valuation (P/E, P/B)
   • dividend yield
   • margins (GPM, OPM)
   • leverage (debt to equity, interest coverage)
   • and this list just goes on!
2. Qualitative – for when you have things that are not easy to measure:
   • quality of management
   • width and depth of business moat
   • reputation of company
   • reputation of major shareholder.
3. Thematic – for when you have a certain view of a certain scenario:
   • geographical focus
   • industry focus.

What's great is that there are no hard and fast rules. These three categories can be used separately or in conjunction with one another in any order that you want to use them in!

And to start you off, here are some online screeners that might help you:

• Singapore: SGX Stockfacts³¹
• Malaysia: Stockhut Mobile App,³² KLSE Screener Mobile App³³
• Global: Financial Times Equity Screener,³⁴ Google Finance Stock Screener.³⁵

Screen Your Screens

A possible investment idea can come along from anywhere: through mainstream media, books and magazines, conversations with friends and even just from our personal experiences.

However, if we assume that it will take you one full day to analyse one company (very optimistic), this means that it would take you more than four years just to look through all the companies listed in Hong Kong. And with so many listed companies, how can we focus our time on those that are really worth it?

To give an example, one way to narrow down your search is by looking from the top of the economy. Imagine this: if China's growth days are far from over, it might not be too far-fetched to assume that the Chinese appetite for consumer goods – things that people eat, drink, wear and use – is still going strong. Sounds familiar? Yes, it's none other than the China consumer story. Again. So bear with us.

Anyway, with the China consumer story still having certain merits, you might be interested in Hong Kong or China-listed consumer staples with a large market cap, specifically market leaders in the food and beverage industry. If you haven't already noticed, those criteria just about ticked all our three quantitative (large capitalisation), qualitative (market leaders) and thematic boxes (China consumer story – Food and beverage industry).

And with just these factors alone, we would have already narrowed our universe from thousands of listed companies down to a fairly workable list. Some of the companies that might have passed our initial screen included names like Hong Kong-listed China Mengniu Dairy Company Limited, Dali Foods Group Company Limited, Tingyi (Cayman Islands) Holding Corporation, Tsingtao Brewery Company Limited, Uni-President China Holdings Limited, Want Want China Holdings Limited and Vitasoy International Holdings Limited.

To show the versatility and utility of screening, let's stick with our example of the China consumer, but in this case focus on the discretionary consumer industry.

As the general wealth level increases, the Chinese consumer patterns get more sophisticated and demand for higher-quality goods could start to increase. With this train of thought, a decent case for a rise in demand for luxury brands in China could be made.

With that idea, we can perform a thematic and quantitative screen to focus on companies:

• In the consumer discretionary space – jewellery and luxury auto players
• With strong growth over the past decade
• With a huge portion of their revenue from Chinese consumers.

Just for reference, some companies in our list could include names like BYD Company Limited, Chow Tai Fook Jewellery Group Limited, Hengdeli Holdings Limited, Luk Fook Holdings (International) Limited, Prada S.p.A and Zhongsheng Group Holdings Limited.

If we wanted to further narrow down our scope, and were interested in the larger HKEX-listed jewellery companies, we could end up with an even smaller list consisting of companies like Chow Tai Fook Jewellery Group Limited, Chow Sang Sang Holdings International Limited and Luk Fook Holdings (International) Limited.

Another way is to just use a quantitative screen to narrow down your options, and likewise you would also arrive at the desired outcome of a handful of companies worth looking deeper into.

With quantitative screening, it definitely helps if you have an online screening tool at your disposal. Most brokerages should have an online stock screener for investors. In any case, there are many free online screeners available on platforms like Google Finance, Yahoo Finance, Morningstar and Financial Times. Beyond that there are also paid services such Bloomberg, Thomson Reuters and S&P Capital IQ. However, given that most of us might only have access to the free online options, we will attempt a quantitative screen with the Financial Times equity screener to show you how it works. Most of these screening tools are quite intuitive to use: input your criteria and let the screener work its magic.

Criteria included with help of the Financial Times equity screener:

• companies listed on the Hong Kong Stock Exchange
• Gross Profit Margin (5Y average) > 20%
• Net Profit Margin (5Y average) > 5%
• Net Income Growth (5Y) > 10%
• Return on Average Assets (5Y average) > 10%
• Return on Equity (5Y average) > 10%
• Dividend Yield > 2%
• P/E Ratio < 12×
• Price to Cash Flow (TTM) < 12×
• Total Debt to Capital < 50%.

With these 10 factors, we ended up with a group of 18 companies.³⁶ Wouldn't you say that this is a much more manageable figure compared with painstakingly combing through a list of over a thousand listed companies?

Furthermore, with less emphasis on the economy-related factors, quantitative screening is associated with the traditional bottom-up style of investing. The bottom-up investor tends to believe that any company, regardless of the industry, might be a good investment so long as it is purchased at an appropriate discount. Or just simply when it is “cheap” enough. Therefore, bottom-up investment strategy emphasises the individual business, looking solely at the merits and valuation of the company.

Additionally, screening is more than just about quantitative values. In fact, depending on the factors we choose, it could give us a rough guide into the qualitative and thematic side of the story. For example, finding companies trading at low Price-to-Earnings and Price-to-Book ratios might be a starting point for us to investigate possible turnarounds or assets plays. Screening for companies with favourable revenue growth trends, good return on capital ratio and trading near 52-week high price might expose us to companies with good growth prospects and positive catalysts. Screens for large cap companies with low leverage ratios coupled with low Price-to-Earnings and Price-to-Book ratios might indicate an industry primed for consolidation.

In any case, the point we are trying to put across is that screening is a very versatile tool. And the objective of screening is always to help you narrow down your search.

The 5-Fingers Rule

After your initial screen, you might still be left with 50–100 companies. At this point you do not want to increase your screening criteria as it might end up being too restrictive. However, focusing on 50–100 companies is still way too many for you to handle. What do we do now?

It's time for the 5-Fingers Rule.

The 5-Fingers Rule is a simple 10-point checklist to put the shortlisted companies through a quick analysis to further narrow down your search to where only the best of the bunch remains. That's the whole idea.

Wondering how this rule came about? Just take a look at your fingers. There's ten right there, five on each hand. Five out of ten is 50% and that's a pass. Thus the idea came about that when companies are able to meet five or more points on our checklists, it would then be worth our time to look into the company in detail.

Our 5-Fingers checklist includes the following ten questions:

1. Can you understand the business?

   The single most important factor when it comes to choosing your investment is to find one that you understand. If you cannot even explain how the company makes its money, it will never be a great investment for you as you will not be able to find the confidence to invest in it.

   For us, we have a very simple way to decide if we understand the business. As long as we still find it hard to understand how the business works after three readings of its annual report, and if there is nothing super-compelling about this company, we would place it in our “too hard” pile of companies and move on.

2. Does the company have a decent track record?

   Although past performance does not necessarily represent the future performance, a clear observation of the company's track record is still extremely valuable. In particular, it shows us the characteristic of the business, the board and management's response to various challenges and also their treatment of shareholders.

   On the other hand, in the case of a newly listed company, you might only have the management's word to show for things. This is where the risk lies. There is insufficient track record for us to judge if the management behaves fairly towards the shareholders. Again, there is nothing wrong for those who favour this style of operating. But for us, we tend to sleep better when invested in companies with a decent operational track record, a rule of thumb being one business cycle.

3. Is the company making money?

   Before all the Captain Obvious jokes come up, we like to say that many people take this fundamental quality for granted. From our experience, many investors still do invest in loss-making companies, in the hopes that they will become profitable. Nothing wrong about this; however it is notable that this approach requires a much higher degree of due diligence from the investor. Given the risk and reward profile, unless we are prepared to do a deep research into the company, to understand the nature of its business, why it is losing money and how it is going to turn the company around, we generally do not recommend investments in consistently loss-making companies. An investor invests to enhance his net worth, and if the company is consistently bleeding, how can its shareholders be enriched? And as Warren Buffett says, “Turnarounds seldom turn.”

4. Does the company have worthwhile profit margins?

   As an extension of the previous point, we can have a rough gauge of how much pricing power the company has just from its profit margins. Most companies with commodity-like products tend to have low profit margins. On the other hand, companies with a consistently high level of profit margins tend to have some sort of moat in their businesses. (Or are things too good to be true? More on that later.)

   To increase our chances of finding better-managed companies with stronger pricing power, we like to focus on companies with a reasonable level of profitability. And although what is reasonable differs from industry to industry, companies consistently delivering operating margins of sub-5% might indicate to us how tough their industry is. And our rule of thumb is that any company with a consistent sub-5% operating margin is considered low for us.

5. Can the company continue profitably in the near future?

   This question focuses on the future. This is important as, although track records are good and all, at the end of the day investing is still a forward-looking game. Even for a company with past operating margins of 20%, that doesn't matter if it could fall to 0% due to a shift in technology. So we want to make sure that the company is not operating in an industry that is facing structural decline. You might not want to be invested in a company specialising in the Yellow Pages phone book business.

6. Does the company have a strong balance sheet?

   Debt is a double-edged sword. In good times, leverage can be used to boost a company's performance. However, in bad times, they can go downhill way faster and way more painfully than you expect. With this happening since the dawn of capitalism, it's not news to us. Even during the recent 2015 oil crisis, many over-leveraged companies in the oil and gas industry were just a covenant away from defaulting on their obligations.

   In our minds, two types of companies employ debt:

   • companies that use debt to boost profitability
   • companies whose business model is dependent on debt refinancing.

   Because downturns are inevitable, we feel much more comfortable with companies with a strong balance sheet position and tend to avoid the latter. Lastly, we like to end this section with one of the 16 factors in Walter & Edwin Schloss Associates LP article “Factors needed to make money in the stock market”: “Be careful of leverage. It can go against you.”

7. Is there a history of excessive shareholder dilution?

   Growth by taking on too much debt might be bad for the company but equal damage can be inflicted through excessive equity financing. This is because every time a company issues new shares to outsiders, it is selling a part of its business.

   What this means is that existing shareholders end up owning less of the enlarged group. Shareholders in a company that expands with excessive equity financing might find themselves gradually owning a smaller and smaller part of the pie.

8. Does the company consistently churn out free cash flow?

   Free cash flow is a measure of how much cash the company is generating from its operations after all its capital expenditure. If a company is not generating any positive cash flow for a long period, we would pay attention, especially when the company needs external funding to maintain its operations. The funding could come from either additional debt or additional equity, both of which if done too often, and excessively, are not desirable for investors.

   At the end of the day, it depends on how much cash the company brings in. Remember this well – cash is a fact, profit is an opinion.

9. Does the company have decent returns on capital?

   A good measure of how well a company is making use of its capital comes from looking at its return on capital. One such ratio is the return on equity (ROE). The ROE is calculated as shareholders' net income over the shareholders' equity. This ratio essentially shows well the company performs with the resources it has. Generally, the higher the better.

10. Is the major shareholder fair?

    In Asia, there is nothing unusual in a major shareholder owning a controlling equity block in the company. In fact, for smaller cap companies, this might be the norm. Note: Major shareholders can also be in the form of another company.

    In any case, we aren't implying anything negative just from a major interest by a shareholder. Instead we are looking from the angle that with such a significant block, a major shareholder might have some say in the company, thus it definitely helps to have at least a basic understanding of a company’s shareholding structure. From it, we need to see if the major shareholder has done anything unfair to minority shareholders, such as excessive compensation or private placements to themselves at sharp discounts in the past.

The Importance of the 5-Fingers Rule

These ten simple questions that can easily be answered with a quick scan of the company's annual reports. As a quick rule of thumb, we should only investigate deeper if it has at least five positive answers from our checklist. Imagine the ten questions as your ten fingers; if it makes you able to grasp it with one hand or five fingers, then it might be worth your time.

Surely, there are exceptions to the rules and we might miss out some great opportunities with this approach. However, when used conservatively, the benefit of avoiding bad investments should outweigh the possibility of missing out on some good investments.

To end our chapter, we like to share this rather useful checklist from Philip Fisher's Common Stocks and Uncommon Profits³⁷ (Table 5.2). Although we might not be able to answer all his questions (and we do not need to), having the curiosity and answers to some of them is already more than enough for us to help in our investment decisions!

Here are 15 of his questions to check if the company is worth his time:

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above-average sales organisation?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labour and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from the anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointment occur?
15. Does the company have a management of unquestionable integrity?