My Foolish colleague, Chong Ser Jing, recently ranked all the stocks in the Singapore market according to the Magic Formula, an investing strategy popularised by Joel Greenblatt in his book, The Little Book That Beats The Market. Ser Jing wanted to find the 30 best stocks in Singapore for 2018, based on the Magic Formula, and Design Studio Group Ltd (SGX: D11) happened to be one of them.
Established in 1992 and headquartered in Singapore, Design Studio is a high-end interior fit-out and joinery manufacturing firm. It has completed several residential, hospitality, retail, gaming and cruise line projects in countries such as Singapore, Malaysia, China, and the US.
Even though Design Studio was ranked highly on Greenblatt’s Magic Formula, would one of the greatest investors in the world, Warren Buffett, be interested in the company? We can’t ask him in person, but we can turn to a six-point acquisition criteria formulated by the Oracle of Omaha to give us some clues to answer the question. However, more importantly, Buffett’s checklist, together with the deep dive into Design Studio’s financials that I did recently, can help investors develop a better understanding of the company.
With that, let’s turn to Buffett’s acquisition criteria.
1. Pre-tax earnings of at least US$75 million
Buffett has this criterion in place because the conglomerate he controls, Berkshire Hathaway, is a near-US$500 billion behemoth, so his acquisition targets need to be of a certain size to move the needle for Berkshire.
In 2017, Design Studio had pre-tax earnings of just S$1.5 million, which is lower than the first criterion. Retail investors looking into Singapore-listed companies, though, should not be too strict about this rule as this might inadvertently sieve out many small-cap quality companies.
2. Demonstrated consistent earning power
The second criterion helps Buffett determine if a company has a stable and/or growing business. Companies that have a history of steady and growing earnings tend to have competitive advantages that help their businesses grow over time.
The table below shows the net profit for Design Studio over the past five years:Source: S&P Global Market Intelligence
Design Studio’s net profit from 2013 to 2017 had been erratic. Last year, its bottom-line plunged to S$1.2 million from S$20.5 million in the previous year. However, things could turnaround in the next few years since Design Studio is embarking on a three-phase transformation strategy that started in 2017 and ends in 2019.
3. Good returns on equity (ROE) while employing little or no debt
This criterion’s purpose is similar to the second: It helps Buffett identify companies with competitive advantages. Generally, a company that has a history of generating good ROE while employing little or no debt has a high chance of possessing durable competitive advantages.
Here’s a table illustrating Design Studio’s return on equity, and total-debt-to-equity ratio, from 2013 to 2017:Source: S&P Global Market Intelligence
The company ended 2017 with an ROE of 1.2% and negligible debt. Its cash balance, as at 31 December 2017, was S$28.9 million; it had S$50,000 in total debt.
4. Management in place
Buffett included this criterion because he did not want to have to provide a management team when he acquires a company. For stock market investors like you and me, this criterion has no real meaning, since public-listed companies almost always have leaders in place. However, this point is a reminder for us to take a look at the people running a company when researching a stock.
The chief executive of Design Studio is Edgar Ramani, who was appointed to the position in February 2017. He is responsible for the company’s overall strategic direction, growth, business development and operations. Edgar, who is trained in civil engineering, has vast experience in delivering turnkey resource and infrastructure projects throughout Australia, South East Asia, India and the Middle East.
5. A simple business
In my view, Design Studio is a simple business to understand.
However, it is worth noting that Buffett had this rule in place to cater to his circle of competence. He is only interested in acquiring businesses that he understands. Going with this train of thought, what I think is a simple business may be complicated for you, and vice versa.
6. An offering price
This is another criterion in Buffett’s checklist that is not applicable for stock market investors, since stocks have quoted prices that are easily seen, unlike the private businesses that Buffett evaluates for acquisitions. This criterion, though, serves as a useful reminder that the price we pay for a stock is critical.
If we overpay for a stock (meaning we invest in a stock at an expensive valuation), the chances of our investment succeeding will be low. A famous quote from Buffett, “Price is what you pay, value is what you get,” rings true here.
Coming to Design Studio, the company last traded at a stock price of S$0.35 yesterday. It was sold at 76 times its 2017 earnings and had a dividend yield of 3.6%.
A Foolish conclusion
The deep dive I did earlier on Design Studio, and the application of Buffett’s checklist should help investors make a better-informed investing decision on the company. Stay tuned for more on the rest of the companies from the 2018 best stocks list. For a repository of all the articles in this new series that uses Warren Buffett’s acquisition criteria to analyse the 30 best stocks, you can head here.
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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 Sudhan P owns shares in Design Studio Group Ltd.