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 Sinostar PEC Holdings Limited (SGX: C9Q) happened to be one of them.
Sinostar is one of the largest producers and suppliers of downstream petrochemical products within the 400 kilometres radius of its production facilities in Dongming Petrochem Industrial Zone, Shandong, China.
Even though Sinostar 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 Sinostar’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, Sinostar had pre-tax earnings of RMB 95.3 million (around US$14.5 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 Sinostar over the past five years:Source: S&P Global Market Intelligence
Sinostar made losses in both 2013 and 2014. However, the company turned profitable from 2015 onwards, and ended 2017 with RMB 68.2 million in net profit.
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 Sinostar’s return on equity, and total-debt-to-equity ratio, from 2013 to 2017:Source: S&P Global Market Intelligence
In 2017, Sinostar had an ROE of 10.6% with no debt. Its balance sheet, as at 31 December 2017, had RMB 438.3 million in cash.
(Note: ROE for 2014 is positive as earnings from continuing operations is positive for the year. Our data provider uses earnings from continuing operations as the numerator instead of net profit to calculate ROE.)
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.
Sinostar’s non-executive chairman is Li Xiang Ping while its chief executive officer and executive director is Zhang Liu Cheng.
5. A simple business
In my view, Sinostar is a complex 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 complex business may be simple 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 Sinostar, the company is now trading at a stock price of S$0.205. This gives a trailing price-to-earnings ratio of around 10 and a dividend yield of 2.4%.
A Foolish conclusion
The deep dive I did earlier on Sinostar, and the application of Buffett’s checklist should help investors make a better-informed investing decision on the company.
With that, we bring this series that uses Warren Buffett’s acquisition criteria to analyse each of the 30 best stocks for 2018 to a close. For a repository of all the past articles in this series, 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.