Michael Leong- Your first $1,000,000 Making it in stocks

 Michael Leong- Local Legend

After exhausting significant part of my war chest, I was very fortunate to chance upon the book published by a Local Legend - Dr Michael Leong. It was my second time rereading the book and the experiences he shared still felt as vivid as ever. 

I first heard of Dr Michael Leong on Hyom Hyom blog whereby ML won significant praise as a wise and selfless investor which is willing to teach and share about his journey and the lessons he learnt. Dr Wealth also had a short writeup on him.

The forums are now defunct and I was under the impression that his teachings had been lost. What I did not realize then is that ML also published a book. I rapidly snapped up this secret manual upon sighting his name in the library shelf. His insight into investing in Singapore is profound and sometimes contradictory, rational yet contrarian and well rooted in the context of Singapore Market. ML has a remarkable mind and strong self control, being able to clearly segregate his long term FA multi-bagger positions from his <gut feel + disciplined take profit / cut loss> short term trading / tikum positions. His emphasis on identifying mega-trends seem more of an art than science, something that linear and less complex minds like mine find it hard to emulate. 

One important takeaway from him is that no two individuals' investing / trading strategy is identical and can be greatly influenced by nature and nurture (life experiences and circumstances). Due to my limited ability to comprehend the technical analysis portion, I shall solely focus to extract nuggets of wisdom from his lessons in fundamental analysis.

Chapter 14 => Red Flag and Creative accounting methodologies (With my personal input)
1) Negative Goodwill 
=> Get a high valuation of private company, do a share swap / acquisition of the stock at a seemingly low price. This gives outsiders the impression that the company paid for much less than the Net Tangible Asset of the private company, and you can rapidly spike up the Net Tangible Asset / NAV of the company.

=> Berkshire acquisition of Kraft Heinz, resulting in Asset and goodwill write-offs

2) Debt to Equity Conversion 
=> After this Corporate action event, the company will no longer suffer from negative equity, and reduce loss per share. This does not change the fundamentals of the company and there is merely more shareholders to share the loss.

=> Prevalent in Noble / Hyflux and company with quasi debt-equity instruments. Best to avoid companies with high debt to not be forced into this option.

3) Aggressive booking of revenue and increase trade receivables 
=> Billing what the company cannot collect. Importance of checking cash flow rather than P/L which can be easily manipulated.

=> Specifically replicated in the S chips saga! Large revenues not supported by operating cash flow!

4) Capitalization of expenses into assets 
=> Covered in my CFA curriculum. Ramping up of research expense and capitalize it to increase profit, as well as increase Net Tangible Assets (Intellectual Property). Could be explained as a timing issue. 

=> Very difficult to prove / disprove as future cash flows are inherently uncertain. Rely on your circle of competence to make a judgement call.

5) Deliberate Conservative accounting in bad years. Aggressive accounting in good years. Dependent on management integrity to not manage earnings.
=> Banks increase their loan loss reserves in expectation for recessionary conditions and spike in bad debt. When economy recover, Loan loss reserve will be added back as equity in the balance sheet. 

=> Very prevalent among banking, insurance  and finance sector.

In the Private sector, when there is a change in CFO/CEO in a bad year, conservative accounting is utilized to write off bad receivables and inventory stockpile whereby monetisation is uncertain. This can be written back in the P/L in a good year.

=> This is some of the IFRS / GAAP tricks that was covered in the CFA syllabus.

6) Acquisition heavy companies 
=> Hide bad years in bottom line, by increasing EPS. Utilize goodwill to inflate as well as hide bad business results in consolidated subsidiary. Potential revaluation / write-up of assets that may not be cash flow ac-creative. Record a large provision to cover the cost of reorganization by writing down assets, leading to no negative change in expense, profitability and PE. 

=> Recognize profit early and defer expenses to register strong earnings, and wait for the hit on cash flow on a later date.
=> Prevalent in the Alibaba and Enron cesspool . 

7) Restating depreciation / amortization policy. 
=> Restating straight line to variable depreciation policy. Noting the depreciation is a non cash expense, this method can improve / aggravate profit numbers with no real improvement in cash position and underlying business performance.
=> This cosmetic procedure is prevalent among airlines and heavy CAPEX industries. 

=> For sales and leaseback of buildings, companies can claim to be asset light by selling their buildings and renting this back. In reality, there is a one time cash inflow but larger monthly expenditure outflow. Spotted in the Hyflux situation. 

8) Creative valuation Metrics 
=> Utilizing research Expense and eyeballs to justify the valuation of the company.
=> Utilizing Profit Guarantees, Deferred Cash and stock payment to recognize profit without punishing earnings. 

=>MAU /DAU is a current favorite metric of Internet based companies which might not transit to underlying cash flow and revenue / profitability.

=> Always remember that in investing, you are making money and not subsiding a charity. If that company is really that great, a few more years won't hurt until it starts to regain profitability.

9) Related party transactions 
=> Case by case basis.  Hard to prove / disprove and dependent on management integrity.
=> Silverlake Axis share price is punished heavily for its use of related party transactions until it decided to improve its corporate governance.

10) Importance of Notes to Accounts 
=> Reality check on whether there is creative accounting involved. Read the fine print!
=> Due to the ingenuity of corporate finance departments, it is far easier to buy companies with a simple business and No debt rather than to figure out what the fine print actually means. 

11) NEVER trust NAV / NTA numbers at face value. 
=> For asset based valuation, ML place higher priority on Cash and Singapore based properties with no debt as he has faith in integrity of SG banking system and he can easily conduct scuttlebutt analysis on the underlying buildings. All other forms of cash equivalent and assets are regarded as secondary. 

=> Beware of accounting games propping up NAV such as negative goodwill, Increase no of creditors, Increasing inventory, Increase in IP and intangible assets as these can be written off easily. 

=> As companies require reinvestment, be wary of management usage of EBITDA as this is a cash flow metric that does NOT reflect the economic reality of underlying businesses . Heavy CAPEX companies like to use EBITDA to promote its cash flow and shy away from the heavy capex nature of the business. 

12) Never trust guaranteed yields unless there are for life.
=> For stocks and property markets, Once there is no cash inflow, economic reality will set in and capital loss will take away what little guaranteed yield that was promised.

=> Dividend investing MUST be supported by underlying cash flow into the company. Due to the vicissitudes of capitalism, wonderful companies with a monopolistic position, strong brand or unique product / market niche serves as a moat.

 => Prioritize P/E followed by cash flow, then dividend yield.

13) Importance of choosing companies with reasonable profit margin
=> Due to the vicissitudes of business conditions and competitive landscape, High profit margin allows the company to absorb any unexpected losses / shocks and allows the company flexibility in pricing and product strategies. A razor thin margin can easily force the company to making losses to continue its operations.

Conclusion

As a businessman and investor, his unique experiences led him to have considerable scepticism on macroeconomic forecasts and even basic cash flow projections by management. His (localised) version of book value / Asset based valuation might uncover interesting opportunities as the market continues to tank. I shall strive to maintain a sufficient warchest as interesting opportunities emerge!