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 Hock Lian Seng Holdings Limited (SGX: J2T) happened to be one of them.
Hock Lian Seng is a construction firm that was started in 1969 with a focus on infrastructure projects. The projects it has completed include MRT depots, bridges, expressways and water infrastructures.
Even though Hock Lian Seng 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 Hock Lian Seng’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, Hock Lian Seng had pre-tax earnings of S$24 million, which is much 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 Hock Lian Seng over the past five years:Source: S&P Global Market Intelligence
In general, Hock Lian Seng’s net profit has trended downwards over the past five years. This could mean that the firm is facing challenges in growing its business.
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 Hock Lian Seng’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 8.9% and negligible debt. Its balance sheet, as at 31 December 2017, had S$132.1 million in cash and S$15.1 million 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 executive director and chief executive of Hock Lian Seng is Chua Leong Hai. Chua is the founder of the company and has over 40 years of experience in civil engineering works in Singapore. He oversees the overall management, formulation of business plans, strategic positioning and business expansion of Hock Lian Seng.
5. A simple business
In my view, Hock Lian Seng 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 Hock Lian Seng, the company last traded at a stock price of S$0.42 on Tuesday. It was selling at a trailing price-to-earnings ratio of 11 and had a dividend yield of 4.3%.
A Foolish conclusion
The deep dive I did earlier on Hock Lian Seng, 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 doesn’t own shares in any companies mentioned.