“Graham’s image of Mr. Market, probably the most brilliant metaphor ever created for explaining how stocks can become mispriced. The manic depressive Mr. Market does not always price stocks the way an appraiser or a private buyer would value a business. Instead, when a stocks are going up, he happily pays more than their objective value; and, when they are going down, he is desperate to dump them for less than their true worth.”
– Jason Zweig, Commentary on The Intelligent Investor.
We all know about the famous Mr. Market coined by Benjamin Graham. Mr. Market is always described as someone who suffers from incurable emotional problems, someone to be taken advantage of. However, I find such thought a misrepresentation. Mr. Market, may be a fool, a sucker to a saint like Benjamin Graham, but to mere mortals like us, Mr. Market is in fact likened to the Devil, deceiving mankind into wrong paths.
Someone was knocking on my door, it was the night of 21st Aug 2017 (I remember the exact date because I kept a journal about it but due to the shift of blog server, I didn’t manage to post it on time. The shift of server also explains the idleness of the blog for the past two months).
It was Mr. Market, carrying a suitcase full of IQGROUP, looked at me excitingly and said ” I have an offer that is too good for you to turn down.”
“I got those already.” I replied without any interest, while closing the door.
“Wait,” He said, holding the door with his arm, “I know you already have some, but do you have enough?”
“Look man, I bought it at RM 2.70. It’s now RM 4.70. I am not going to buy more at this price.” (I first posted IQGROUP write-ups on 8 January 2017 & 15 January 2017, at the price of RM 2.70)
“Wow wow wow, are you price investing or value investing.” He said it to provoke me, “I know what they told you about me. They said I am a lunatic, but I assure you I speak only figures and facts. Now, if you would let me in, I promise, just figures and facts.”
I nodded, and let him in.
“So boy, tell me, what made you bought IQGROUP six months ago?” He asked.
“The shifting from ODM to OBM, which will result in margin expansion, It will transform from a manufacturer to a technology company. In fact, it is already more of a technology company, rather than a manufacturer. Besides, the company balance sheet, cash flow, management and return on capital is excellent.” I replied.
“Damn right. Two financial quarters have passed since your write-up, we can now see that the net profit margin expanded from 9.5% in FY16 to 12.5% FY17. What is more impressing, perhaps, it is the ROIC that increased from 19.7% in FY16 to 23.8% in FY17. The company remains cash rich, good cash flow and I see better transparency in latest annual report.” He said, ” And don’t forget, I only include core profit in my figures.”
“Yes, we have to exclude non-core profits (eg. Foreign Exchange gain), especially for company like IQGROUP that export 99% of its products to overseas.” I had to agree with him.
“Now, you agree that IQGROUP is a very good company, what’s stopping you from buying more?”
“The valuation.” I replied with hesitation, “At the time I bought IQGROUP was only trading at P/E 10.5x; EV/EBIT 6.3x, now it is trading at P/E 17x; EV/EBIT 12.66x. I don’t think it is reasonable for a company at this size to trade at such valuation.”
“Urgh! PE! EV/EBIT! If I get a coin every time I hear this.” He rolled his eyes and continued, “You told me yourself, it is going through a transitional period from ODM to OBM. Do you expect a manufacturer to trade at the PE as a technology company? You can easily find few dozens of stocks trading at PE 10x or lower, tell me, why aren’t you buying them?”
“Mostly because of their subpar business model, or management inefficiencies, which leads to low Return On Capital.” I replied.
“Exactly. Return on capital. That’s the key. When we talk about value investing, it is either buying fair business at wonderful price, or buying wonderful business at fair price. Wonderful business doesn’t come cheap!” He said.
“Yes, I agree. But that doesn’t mean we should jump into any good business without considering the valuation.” I replied.
“Of course valuation is part of the consideration!” He was offended, “Tell me, Business A is trading at 20x, with Return On Invested Capital (ROIC) of 25%, while Business B is trading at 10x, ROIC of 10%. Assuming both businesses have the same reinvestment rate, and the return maintains for the next 10 years and in year 10 PE ratio normalizes to 15x for both Businesses, which one is going to worth more?”
“It has to be Business A, it is mathematically proven.” I replied, “Time is always a friend to wonderful company, Business A will outperform Business B as time passes.”
“Yet, in real life you wouldn’t think Business B is expensive. But you think IQGROUP is expensive, which is only trading at PE 17x with ROIC of 25%.” He laughed at me.
Now you see, Mr. Market is good at what he does. As he promised, facts and figures only. He knows exactly what you believe in, and turns them against you. I didn’t buy more after Mr. Market visit, neither did I sell my holdings,
Just one week (29th Aug 2017) after his visit, IQGROUP released its 1QFY18 Financial Report, Revenue and Net Profit drop -16% and -60% yoy respectively, sending the share price to RM 3.11 (at time of writing). It immediately got my attention to review this company.
Looking at the latest quarter result (1QFY18) alone, it is no doubt the worst result in recent 6 financial quarters, with Revenue and Net Profit drop -16% and -60% yoy. However, if we remove non-core income in both financial quarters (1QFY17 vs 1QFY18) from our analysis, the net profit dropped only 41.55%. The reason of the drop was not made clear in the quarter report. We received an unverified source of information which claims to be the direct reply from IQGROUP Group Financial Controller, that the decline in revenue and hence profit is mainly due to the delay in IQGROUP new product launching for existing ODM customers. It is also said in the message that IQGROUP is currently facing some challenges on R&D resources to support the ODM business as its current R&D attention and focus is on their own products (OBM) which meets IQGROUP’s long term strategy to transform from ODM to OBM. The Group is very confident of the Outlook of the OBM segment.
Here are some takeaways from IQGROUP TTM1QFY18 financial analysis:
Gross Profit Margin 56% (56% in FY17, 43% in FY12)
EBIT Margin 14.2% (14.2% in FY17, 0.8% in FY12)
Net Profit Margin 12.4% (13.1% in FY17, 0.5% in FY12)
Net Cash per Share 65 cent (65 cent in FY17, 11 cent in FY12)
Current Ratio 5.27x (4.9x in FY17, 2.55x in FY12)
ROIC 21.5% (23.8% in FY17, 1.4% in FY12)
i) Please refer to Table 1 for more information.
ii) Our figures in Table 1 excludes non-core income in calculation.
iii) Dividend is being assumed to remain the same in FY18.
Table 1: Financial Analysis of IQGROUP
Think about the reasons we look into IQGROUP in the first place (as stated in the conversation with Mr. Market), Margin Expansion in IQGROUP is still very obvious over the 6 Financial Years. This is in line with the Group’s path in shifting from OEM to ODM, and ODM to OBM.
Balance Sheet wise, with zero debt, Net Cash per Share of IQGROUP is now 65 cent, equivalent to 20% of market capitalization. Its liquidity ratio is getting stronger than ever.
What is the most impressive thing about IQGROUP to me perhaps is its high ROIC of over 20% in the past three financial years (again we didn’t include non-core earnings in our analysis). These are very impressive numbers and relevant to IQGROUP as a technology company that relies heavily on R&D to ensure future growth.
To be fair, however, IQGROUP latest quarter report is really not a good one. Punishment is unavoidable, but the question is, how far would you punish a company with good track record and bright prospect for a temporary setback?
When we talk about value investing, it is either buying fair business at wonderful price, or buying wonderful business at fair price. For the former, finding Intrinsic Value is important as we aim to buy them cheap and sell them at a fair price. For the latter, that is buying wonderful business, Compounding Intrinsic Value is more important as we aim to see our capital to grow with the company over the years.
Basically, a business will grow its intrinsic value at a rate that equals the product of two factors: the incremental return on invested capital (ROIC) and the reinvestment rate.
Compounding Intrinsic Value = ROIC x Reinvestment Rate
Using IQGROUP as an example, the average ROIC for past 3 financial years is 20% and Reinvestment Rate of 60% ( 1 – Dividend Payout Ratio). Thus, the Compounding Value for IQGROUP would be 12% per annum.
If I opine the fair value for a company like IQGROUP to be trading at EV/EBIT of 8x (setting its growth prospect aside), the fair price would be RM 3.00 (based on TTM 1QFY18). I further assume IQGROUP to be able to sustain its ROIC of 20% and maintain Reinvestment Rate of 60%, which resulting in Compounding Intrinsic Value of 12%.
With the above assumptions, the intrinsic value for IQGROUP would be RM 4.21 in 3 years time. Of course, it goes without saying that the figure derived merely based on your assumptions. If you are conservative, you can start with a lower fair value (eg. EV/EBIT of 6x). You may also adjust the ROIC upward or downward, and re-estimate the investment period (for eg. ROIC of 20% in next 2 years, then ROIC of 15% for the following 5 years).
However, one should not just input the figures from any listed company to justify his/her buying decision. Other aspects of the company are needed to be examined as well which includes but not limited to balance sheet strength, business model, competitive advantage, management capability, cash flow, and transparency.
Here are few questions for readers before ending this article:
1) On the night of Mr. Market’s visit, he must have visited other investors too. If you were one of them, would you have bought more, or remained your holdings, reduced your holdings? Why?
2) After reading this article, would you now think IQGROUP is a good company to own at current price (RM 3.11 at time of writing)? Why and why not?
3) Would your decision in Question 1 affect your decision in Question 2? Why and why not.
I would like to end this article with 3 key points:
1) The greatest trick the Devil ever pulled was convincing the world he didn’t exist, and the greatest trick Mr. Market ever pulled was convincing the world that he was an idiot.
2) Always keep the Holy Bible of Value Investing, The Intelligent Investor close to you, and it is meant to be read, re-read, and re-read.
3) I personally think IQGROUP is a very good company, and it is now trading at relatively lower valuation.
IQGROUP Annual Report FY12-FY17
IQGROUP Financial Report 1QFY18