How Should We Invest?

Credit: Simon Cunningham

Not too long ago, I was reading an annual report of the conglomerate SembCorp Industries Limited without realising that my younger 19-year old cousin had been standing next to me for a few minutes.

Confused, he asked me how I could bear reading such a boring report. Naturally, I tried to explain investing and making money to him. During our conversation, he asked many questions, but one stood out:

“You said you want to buy good companies at a cheap price. How is that possible? Good things are never cheap. Just look at my Air Jordan sneakers. It’s never cheap! If you want cheap stuff, usually they are of bad quality!”

Though he has never invested in his life, he knew a simple everyday investing reality: High-quality things and cheap prices do not come together most of the time. Usually, we’d need to find a trade-off between price and quality.

But this raises the question: Should we first focus on price or business quality when making investing decisions?

Going for bargains: A cheap price

There are a group of investors, usually known as deep value investors or net-net investors, who focus first on price before looking at the business.

For this group of investors, they try to buy really cheap companies that still have functioning businesses – though the businesses usually have poor economics. The focus for these investors is on a company’s balance sheet – the hard assets such as cash and property.

The benefits of such an investing style is that, if your price paid is low enough, you will not lose much in your investment since the price is supported by the value of the assets.

The risk, however, is that the intrinsic value of the businesses you’ve invested in (in other words, the asset values) may decline over time.

For deep value investors, companies like SembCorp Industries Limited (SGX: U96), Cosco Corporation (Singapore) Limited (SGX: F83), Golden Agri-Resources Ltd (SGX: E5H), and Wilmar International Limited (SGX: F34) may be of interest for further investigation.

Company Price-to-book ratio
(as of 4 Jan 2016)
SembCorp Industries 0.82
Cosco 0.74
Golden Agri-Resources 0.33
Wilmar International 0.87

Source: S&P Capital IQ

As you can see from the table above, the aforementioned quartet of companies are all currently trading below their respective book values.

Hunting quality: A good business

Another group of investors, who may find inspiration from investing legends like Warren Buffet and Charlie Munger, focus on good businesses. These are companies that can compound their value over a long period of time.

For this group of investors, the return on their investment in a company derive from the effective use of capital by the management team to continuously grow the per share intrinsic value of the firm.

The benefits of investing in this way is that you only need to make a few good decisions and stick to your investments for a long time until your companies eventually stop compounding their values.

The risks however, are two fold. Firstly, you might be wrong about the economics of a business.

Secondly, and more importantly, good businesses do not usually sell at low prices based on traditional valuation metrics like the price-to-earnings (PE) or price-to-book (PB) ratios. It can be tough to judge if a high-quality company is actually a long-term bargain when it is carrying high valuation metrics. Overpaying for shares, even for those of a good company, will not give you a satisfying return in the long run.

An example of what may possibly be a high quality company is healthcare services provider Raffles Medical Group Ltd (SGX: R01). The company’s shares have climbed by more than 650% in price over the past 10 years, with its profit more than tripling from S$12 million in 2005 to S$67.6 million in 2014.

Raffles Medical is currently valued at a high PE ratio of 34, which is nearly thrice the SPDR STI ETF’s (SGX: ES3) PE ratio of 13; the SPDR STI ETF is a proxy for Singapore’s market barometer, the Straits Times Index (SGX: STI).

Foolish Takeaway

There is no single right way to go about for successful investing. Investors should consider their own temperament and circle of competence before deciding on what type of investing approach to focus on.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.