Stocks

Stockholders own a share of the company in which they are invested. Stocks are traded on an exchange and prices are set by the market. Stock prices are typically driven by financial results, company news and industry fundamentals. They are usually valued on a “multiple” basis. Stock investors generally invest in companies that they feel have superior growth prospects and are undervalued by the market. While the market sets the prices and no one shareholder should be able to influence prices, stockholders have a way of influencing management and company decisions via proxy voting. Stockholders only receive “payment” for their investment when the stock price increases or dividends are paid.

Bonds

Bondholders differ from stockholders because they do not have any ownership stake in the company. Instead, bondholders essentially lend a corporation money under a set of rules/objectives (covenants) the company needs to follow to maintain good standing with the bondholder. Once the bond matures, bondholders receive the principal investment back from the company. In the meantime, they receive coupon, or interest, payments on the bond (usually semiannually).

Bonds are traded in the bond market and prices are set by the market based on the financial fundamentals of the company issuing the bonds (most notably the strength of a company’s balance sheet and the ability of the company to pay its obligations). Bonds have an inverse price and yield relationship, such that bonds sell at a premium when they are less risky (meaning the coupon is low) and at a discount when the risk is higher. The principal does not deviate and is therefore called the face value, but the coupon and price do change based on perceived financial strength and investors expectations about the company.

Bonds are rated by rating agencies (Standard & Poor’s, Moody’s, Fitch) based on their characteristics. When any of these agencies changes its rating, market prices fluctuate. Therefore, bonds are also subject to market speculation of rating changes. Investment grade bonds are generally considered safe from financial failure, while high-yield bonds are much riskier.

Stock or Bond Investment?

Companies face many decisions that affect investors. One of the greatest conflicts between investors and companies is that what is good for one stakeholder may not be good for the other. Let’s take a look at some situations that may benefit or hurt stock and bondholders’ positions.

Situation 1: A Company Borrows Money to Expand When a company borrows money, stockholders’ earnings per share (EPS) is negatively affected by the interest the company will have to pay on the borrowed funds. However, borrowed funds do not dilute stockholders’ holdings by increasing shares outstanding and may benefit from increased sales revenue from the expansion. Bondholders, on the other hand, may face a decline in the value of their investment as the company’s perceived risk increases as a result of its increased debt load. Risk increases, in part, because the debt could make it harder for the company to pay its obligation to bondholders. Therefore, under a typical scenario, stock prices will be less affected than bonds when a company borrows money.

Situation 2: A Company Buys Back Stocks When a company announces a stock buyback, stockholders are generally pleased by this announcement. That is because stock buybacks reduce shares outstanding so the profit is spread among fewer shares resulting in higher EPS for each share and, in general, a higher stock price. On the other hand, bondholders are usually not happy with this type of announcement as it cuts the company’s cash on hand and reduces the attractiveness of the balance sheet. Therefore, under a typical scenario, stock prices will generally react more positively than bond prices.

Situation 3: A Company Files For Bankruptcy When a company files for bankruptcy, the stock usually falls precipitously. The company’s bonds are also faced with a sell-off, although the degree to which this occurs depends on the situation. The difference in the degree of negative reaction between stocks and bonds is that stockholders are the lowest priority in the list of stakeholders in a company. Bondholders have a higher priority and, depending on the class of bond investment (secured to junior subordinated), receive a higher percentage of invested funds. Therefore in this situation, bond prices will typically hold up better than stock prices.

Situation 4: A Company Increases Its Dividend When a company increases its dividend, stockholders receive a higher payout. Bonds, on the other hand, face pressure as the company reduces its cash on hand because this could interfere with its ability to pay bondholders. As a result, stocks generally react favorably to this announcement while bonds may react negatively.

Situation 5: A Company Increases Its Credit Line When a company increases its credit line, stocks are generally unaffected. At best, stocks may react positively because the company will not try to issue new shares and dilute current shareholders. Bonds, however, may react negatively because it could be a sign that a company is increasing its borrowed funds. However, if there is a cash squeeze in the short term, it may mean the company can meet short-term obligations, which is positive for the bondholders.

Conclusion

Any potential investment should be based on a company’s fundamentals while considering the potential likelihood of various situations or scenarios that may impact the investor. After finding a company that meets your investing criteria, a decision on whether to invest in the bond or stock needs to be made. Continually reviewing the investment in light of changes based on company decisions is a necessary component of any investment strategy.

The steps to calculate stock intrinsic value, also known as fair value, is by summing up 10 years of future net operating incomes that is discounted to present value. I use 10 years assuming that no company will last forever and remember that present value of money is always more valuable than value of money in future of exact amount. In order to calculate present value of money in N year in the future, we simply multiply the amount by 1/1.04N (to the power of N) where N is number of years. To make thing simpler, think of 1/1.04N as factor of money depreciation over a number of years. Then I assume a risk free interest rate of 4% (the current risk free interest rate is ridiculously low which is less than 1%, so I adjusted the percentage to a more realistic depreciation rate of 4%)

But wait. How do I know the company future operating income if it hasn’t come to past? Good question, we seriously won’t know how the company will fare in the future except looking at the historical performance. From historical data, you can get the compound annualized growth rate, and then use the key figure to derive the estimate operating income for the future 10 years.

Recently Genting’s stock has been beaten down a bit from RM7.60 to RM6.50 now. So I took some liberty to find out Genting stock’s fair price. I plugged some of Genting’s financial key figures into my spread sheet. First I extract their past six years of net cash from operating income:

From year 2004 RM 1,685 millions, the operating income has grew up to RM2,551 million in year 2009. The compound annualized growth rate is 7.15%. I then use 7.15% as the average growth rate to estimate Genting’s future operating incomes, I arrive at:

Remember that, money in the future worth less in the present? So we need to multiply each year operating income by the depreciation factor (1/1.04N), then we arrived at:

Notice that estimated operating income in 2019 before and after depreciation factor has a huge different. RM 3,553 vs. 5,259 millions before depreciation. Now sum up the operating incomes from 2010 till 2019, we get RM 30,752 millions, the total operating incomes of the next 10 years.

Now, in order to get one share’s intrinsic value/fair value, we only need to divide RM 30,752 millions by number of share issued in the public, in this case, roughly 3.8 billions shares. The result is RM8.30, versus current market price of RM 6.5.

By looking at the stock intrinsic value vs. market price, there is a margin of safety of RM 1.80 if we purchase the stock at RM6.50. However, to arrive at RM 8.30, we must assume that the earning will be steadily increasing for the next 10 years, a slightly lower earning in one of those years, we will need to readjust the fair value accordingly. On the other hand, if the earning growth rate jumps higher, then the fair value will be higher as well (such as when Genting Singapore starts to fly). Of course there might be some other factors or developments in the company that could largely affect the fair value per share such as change in number of share outstanding or some other factors that you deem might hurt company’s future prospect, you can always discount the fair price accordingly.

As my previous article mentioned, 26% of the total fund (Reported amount RM370 Bil, suspect over RM400 Billions as of this writing) is invested in stock market within Malaysia and some oversea. The recent trend obviously indicates that EPF has been very active in the business arena and stock market, such as recently they extend general offer to buy out MRCB and increasing oversea equity allocation. There are also rumors that the potentially bought out company will be the beneficiary of the mega project EPF join venture with the government in Sungai Buloh that has estimated development value of RM5 Billlions. Though later, EPF cooled down on MRCB deal after many criticism appeared.

With all this moves by EPF, it’s hard not to think that EPF has getting more risk appetite as days go by. Though largely I’m stock investor myself, I’m very much aware of the risk I’m exposed to the market every single day I’m invested. On every investment i make in stock market i will evaluate for several days of weeks plus some observation on the company and movements. How much thought do these fund managers give when investing the EPF money in any assets, especially when the gigantic sum of money is not belong to them, much like any private fund manager such as Public Mutual, they are only investing largely peoples money. How much care they have over peoples money, that is the answer we need to know. Do any of them take accountability and responsibility in person or corporate integrity on the investment decision they make and back it up? If the answer is either vague or unclear, more likely you have no place to cry at when the EPF investment comes back with huge losses, while the so called responsible firm will start to point finger. There are simply no transparency, you might say “Yeah, That’s call Malaysia”. True, but let me put thing into perspective, if you invest in any stock, you as shareholder has voting right in the company’s strategic decisions like appointing new directors. EPF on the other hand, contributors own almost 100% of the fund don’t even get a peek at the company’s balance sheet, and income statement. So, what the hell? In a developing country, this kind of thing which usually deem as outrageous in developed countries is still a norm.

Even EPF loses money in stock market, that’s still not a very serious problem in short term, after all 26% out of 370 Billions is only RM96.2 Billions, besides, EPF has waves of recurring income in hundreds of millions ringgit every month. In the event of EPF making losses, the likely potential problem for EPF to tackle is paying out to the retirees who demands for withdrawal. They can easily solve this by paying these retirees with the recurring incomes, given the total amount of withdrawal does not exceed the total contribution overall for a period of time. For a country with more young working generation this might not be a problem because there are always enough people in the work force contributing to the retirement of some one else. However as the age of the country is catching up, it’s very likely we will see number of retirees increases in ratio to contributors. This has already happen in an ultra modern country like Japan where the age is catching up because many working class chose to be single thus the birth rate is low and the population of young generation simply can’t catch up to the aging old generation. If that’s the case, EPF will have a very hard time catching up to the fund accumulation for any investment returns, the losses in present, even in small percentage will have large crippling effect to future generation in term of ability for EPF to pay back. If that happens, i doubt they will be able to pay even 1 percents of dividend given the money comes in from east and out to west. This is the classic scenario of credit user – use the money now and pay (or suffer) later.

Having said all this, I’m not opposing to any investment moves EPF has done. So far they have done an amazing job (at least it appears to be, in general reporting) with return of 5.65% in dividend for such a clumsy fund size. However, given the non transparent nature of the investment strategy, EPF should always be reminded that the fund need to be taken care of with extreme due diligent – Do not forget that the money is peoples’ hard earned money of their entire life and some people will die losing it. Of course it will be better if the EPF can provide some form of reporting resembling listed corporate annual report including the essential financial statements so contributors can have some understanding of EPF fund’s health as a whole instead of remain ignorant.