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Would Warren Buffett Be Interested in Lung Kee (Bermuda) Holdings Limited, the Third-Best Stock in Singapore for 2018?

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 Lung Kee (Bermuda) Holdings Limited (SGX: L09) happened to be one of them.

Headquartered in Hong Kong, Lung Kee is engaged in manufacturing and marketing of mould bases. It is also involved in the trading of metals and parts. Lung Kee has a primary listing on the Hong Kong stock exchange and a secondary listing here in Singapore.

Even though Lung Kee 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 Lung Kee’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, Lung Kee had pre-tax earnings of HK$384.6 million (around US$49 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 Lung Kee over the past five years:Source: S&P Global Market Intelligence

Lung Kee’s net profit had improved from HK$145.2 million in 2013 to HK$278.3 million in 2017, translating to a compounded annual growth rate of 17.7%.

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 Lung Kee’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 12.1% and no debt. Its balance sheet, as at 31 December 2017, had HK$673.9 million in cash.

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.

Lung Kee’s chairman is Siu Tit Lung while its managing director is Siu Yuk Lung. Both are co-founders of the group and have vast experience in metal trading and mould base manufacturing.

5. A simple business

In my view, Lung Kee 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 Lung Kee, the company last traded at a stock price of S$0.715 on Tuesday. It was selling at around nine times trailing earnings and had a dividend yield of 6.8%, excluding special dividend.

A Foolish conclusion

The deep dive I did earlier on Lung Kee, 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.