Value Investing

Show Me The Ideas!

By Alex Lanoie

Now that the Investment Decision System series is done, it’s time to start applying it. This week, I’ll share with you where I looked this time to find new investment ideas and what I focused on. Referring to the IDS series, this would be Step #2 and Step #3.

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Greenblatt, show me ideas!

Joel Greenblatt

As mentioned in the past, I am lucky to have access to the financial information provider Capital IQ. CapIQ offers a multitude of different ways to filter and find attractive investment ideas, all online. One of the options it offers is a selection of idea generation screens. These screens are pre-programmed screens, which already include several screening criteria and formulas to facilitate the idea generation phase. One of these screens is named the Greenblatt’s Magic Formula Score. If you haven’t done so yet, I suggest you read my post about the Magic Formula (Link: Making money like magic?). The Magic Formula can be very useful in finding potential targets and CapIQ makes it even better by allowing you to modify the “original” Magic Formula to improve on it or adapt it to your needs.

This time, I modified the CapIQ Magic Formula to focus on Hong Kong-listed stocks, with a market cap of US$950 million or above (if I input US$1 billion or above, I’ll miss the companies with a market cap of just under US$1 billion… that’s where the US$950 million comes from – a 5% margin). The first 50 results of the list are shown in the table below.

Company NameTickerMarket Capitalization [My Setting] [Latest] ($USDmm, Historical rate)Greenblatt Earnings YieldCustom Data Point[Greenblatt Earnings Yield]:  Percentile  Relative to Screen Results
(Highest = 100)
Greenblatt Return on CapitalCustom Data Point[Greenblatt Return on Capital]:  Percentile  Relative to Screen Results
(Highest = 100)
Magic Formula Score
Gemdale Properties and Investment Corporation Limited (SEHK:535)SEHK:535                                             1,602.0                          0.163                                                97.01                          3.33                                                  98.8                195.81
BAIC Motor Corporation Limited (SEHK:1958)SEHK:1958                                             9,424.0                          0.214                                                  98.2                        0.606                                                95.81                194.01
IGG Inc (SEHK:799)SEHK:799                                             1,345.7                          0.128                                                91.62                        0.766                                                97.01                188.62
China Lesso Group Holdings Limited (SEHK:2128)SEHK:2128                                             1,960.4                          0.147                                                94.01                        0.374                                                92.22                186.23
Dongyue Group Limited (SEHK:189)SEHK:189                                             1,307.3                          0.149                                                95.21                        0.324                                                86.83                182.04
Harbour Centre Development Limited (SEHK:51)SEHK:51                                             1,329.5                            0.16                                                96.41                        0.318                                                85.03                181.44
Yuzhou Properties Company Limited (SEHK:1628)SEHK:1628                                             2,087.7                          0.217                                                  98.8                            0.3                                                81.44                180.24
China SCE Property Holdings Limited (SEHK:1966)SEHK:1966                                             1,623.9                            0.11                                                88.02                        0.349                                                91.02                179.04
Miramar Hotel and Investment Company, Limited (SEHK:71)SEHK:71                                             1,303.0                          0.113                                                89.22                        0.325                                                87.43                176.65
Logan Property Holdings Company Limited (SEHK:3380)SEHK:3380                                             5,253.8                          0.135                                                92.22                        0.311                                                83.83                176.05
Yuexiu Transport Infrastructure Limited (SEHK:1052)SEHK:1052                                             1,198.5                          0.085                                                75.45                          3.63                                                  99.4                174.85
CITIC Telecom International Holdings Limited (SEHK:1883)SEHK:1883                                                965.4                          0.097                                                82.63                        0.362                                                91.62                174.25
Tianneng Power International Limited (SEHK:819)SEHK:819                                                951.1                          0.185                                                  97.6                        0.273                                                76.05                173.65
Texhong Textile Group Limited (SEHK:2678)SEHK:2678                                             1,158.7                          0.156                                                95.81                        0.276                                                77.25                173.05
Future Land Development Holdings Limited (SEHK:1030)SEHK:1030                                             3,184.4                          0.086                                                77.25                        0.436                                                94.61                171.86
Powerlong Real Estate Holdings Limited (SEHK:1238)SEHK:1238                                             1,782.0                          0.106                                                86.83                        0.311                                                84.43                171.26
Sichuan Expressway Company Limited (SEHK:107)SEHK:107                                             1,684.8                          0.079                                                72.46                        0.975                                                  97.6                170.06
Pacific Textiles Holdings Limited (SEHK:1382)SEHK:1382                                             1,500.5                          0.087                                                79.64                        0.343                                                90.42                170.06
Jiayuan International Group Limited (SEHK:2768)SEHK:2768                                             1,865.7                          0.077                                                69.46                        0.427                                                94.01                163.47
Fufeng Group Limited (SEHK:546)SEHK:546                                             1,654.9                          0.147                                                94.61                        0.232                                                67.07                161.68
Nexteer Automotive Group Limited (SEHK:1316)SEHK:1316                                             5,600.1                          0.078                                                71.86                        0.329                                                88.62                160.48
Imperial Pacific International Holdings Limited (SEHK:1076)SEHK:1076                                             1,993.6                          0.067                                                62.28                        0.654                                                96.41                158.68
United Company RUSAL Plc (SEHK:486)SEHK:486                                             9,367.1                          0.086                                                76.65                        0.284                                                79.04                155.69
China Railway Signal & Communication Corporation Limited (SEHK:3969)SEHK:3969                                             6,431.2                          0.126                                                91.02                        0.216                                                64.67                155.69
Yadea Group Holdings Ltd. (SEHK:1585)SEHK:1585                                                970.9                          0.106                                                87.43                        0.233                                                67.66                155.09
Xinyi Solar Holdings Limited (SEHK:968)SEHK:968                                             2,592.4                              0.1                                                85.03                        0.237                                                69.46                154.49
SMI Holdings Group Limited (SEHK:198)SEHK:198                                             1,412.6                            0.06                                                58.68                        0.502                                                95.21                153.89
China Resources Pharmaceutical Group Limited (SEHK:3320)SEHK:3320                                             7,998.5                          0.087                                                79.04                        0.246                                                71.26                  150.3
Crystal International Group Limited (SEHK:2232)SEHK:2232                                             2,631.0                          0.051                                                  50.9                          1.11                                                  98.2                  149.1
Beijing Tong Ren Tang Chinese Medicine Company Limited (SEHK:8138)SEHK:8138                                             1,143.6                          0.078                                                71.26                        0.273                                                76.65                  147.9
Zhou Hei Ya International Holdings Company Limited (SEHK:1458)SEHK:1458                                             2,139.9                          0.078                                                70.66                        0.268                                                74.85                145.51
Fu Shou Yuan International Group Limited (SEHK:1448)SEHK:1448                                             1,696.8                          0.056                                                56.29                        0.321                                                85.63                141.92
China Traditional Chinese Medicine Holdings Co. Limited (SEHK:570)SEHK:570                                             2,301.4                          0.081                                                73.05                        0.234                                                68.86                141.92
CIFI Holdings (Group) Co. Ltd. (SEHK:884)SEHK:884                                             4,212.2                          0.087                                                80.24                            0.2                                                60.48                140.72
Haitian International Holdings Limited (SEHK:1882)SEHK:1882                                             4,705.6                          0.081                                                73.65                        0.216                                                64.07                137.72
China Energy Engineering Corporation Limited (SEHK:3996)SEHK:3996                                             5,030.4                          0.123                                                90.42                        0.161                                                46.71                137.13
Xiabuxiabu Catering Management (China) Holdings Co., Ltd. (SEHK:520)SEHK:520                                             1,624.0                          0.051                                                  49.7                        0.322                                                86.23                135.93
Dali Foods Group Company Limited (SEHK:3799)SEHK:3799                                           10,895.3                          0.056                                                56.89                        0.281                                                78.44                135.33
Honbridge Holdings Limited (SEHK:8137)SEHK:8137                                             2,056.2                          0.053                                                54.49                        0.279                                                77.84                132.34
YiChang HEC ChangJiang Pharmaceutical Co., Ltd. (SEHK:1558)SEHK:1558                                             1,347.2                          0.065                                                60.48                        0.254                                                71.86                132.34
Sino Biopharmaceutical Limited (SEHK:1177)SEHK:1177                                           10,031.1                          0.048                                                43.71                        0.328                                                88.02                131.74
Qingdao Port International Co., Ltd. (SEHK:6198)SEHK:6198                                             4,169.7                          0.103                                                85.63                        0.152                                                46.11                131.74
Tian Ge Interactive Holdings Limited (SEHK:1980)SEHK:1980                                                963.8                          0.074                                                65.87                        0.219                                                65.27                131.14
DYNAM Japan Holdings Co., Ltd. (SEHK:6889)SEHK:6889                                             1,209.1                          0.142                                                93.41                          0.12                                                35.93                129.34
Tong Ren Tang Technologies Co. Ltd. (SEHK:1666)SEHK:1666                                             1,756.2                          0.091                                                81.44                        0.161                                                47.31                128.74
Tongda Group Holdings Limited (SEHK:698)SEHK:698                                             1,602.4                          0.075                                                67.07                        0.199                                                59.88                126.95
Emperor International Holdings Limited (SEHK:163)SEHK:163                                             1,213.6                          0.049                                                44.91                        0.301                                                82.04                126.95
Joy City Property Limited (SEHK:207)SEHK:207                                             2,148.0                            0.07                                                64.67                        0.212                                                62.28                126.95
United Energy Group Limited (SEHK:467)SEHK:467                                             1,848.1                          0.117                                                89.82                        0.124                                                37.13                126.95
China Hongqiao Group Limited (SEHK:1378)SEHK:1378                                             8,790.9                          0.092                                                82.04                        0.143                                                43.71                125.75

I started going through the list from the top down as better quality ideas (using Greenblatt’s system) should normally be at the top. I had a quick look at each company’s business and financials and identified a few which could potentially be interesting. At this point, I only spent a few minutes per company looking at their details.

In the top 5, there is a company which attracted my attention named IGG Inc. (799.HK). So I decided to bring this potential target to the next step and put it through my first level filter – the primary fundamental factors.

IGG Inc… a good play?

Below is a quick profile snapshot of the company which I pulled out of my idea database and which was populated using the info presented in CapIQ. Again, at this stage, I want to keep it simple. Going through this first filter should take me at most a few hours. The objective is not to make a decision of buying or not, the objective is to see if the idea is worth spending more time on.

Name:IGG Inc.
Stock code:799.HK
Market cap (US$m):1,346
Founded in:2006
Listing date:18/10/13Transferred from GEM on 07/07/2015
Headquarters:Singapore
Business description:IGG Inc, an investment holding company, engages in the development and operation of mobile online games in Asia, Europe, North America, and internationally. The company offers free-to-play mobile, browser, and client-based online games in 18 languages. It also licenses online games; researches and develops games; and provides customer support services, as well as performance-based mobile advertising services for app publishers. The company was founded in 2006 and is headquartered in Singapore.

As a reminder, my primary fundamental factors are 1) Strong business, 2) Great potential, 3) Undervalued, and 4) Strong ROC.

Is it a strong business? Here I focus on: how does the company make money? What’s the sales segmentation? How has the business grown? How good are the profit margins? How does the balance sheet look like?

Although IGG offers free-to-play games, it makes money by charging players a fee if they wish to play with a premium version of a certain game or play with added features. The business therefore seems highly dependent on the success of the specific games they release every year. These online games generate 98% of the firm’s revenues, so that’s basically all they do. It is a very high growth business (59% revenue growth last year) and generates EBITDA margins of over 25% and net margins of over 20%. The company generates huge amounts of cash from its operations and has zero debt.

Next, how’s the potential of the business? How’s the industry growing? How is the market structured? How much of an opportunity is there?

I am far from being an expert in the gaming industry, but it does seem like the mobile gaming market is growing at a staggering pace and it doesn’t look like it will be slowing down anytime soon. However, high margins and a large market means more market players will enter, which will make the environment increasingly competitive. It also seems that unless you have scale and a very strong established team churning out good (or excellent) games consistently, other industry players will eat you up by releasing newer and sexier games. So, the opportunity is there, but the industry structure could be quite challenging.

How’s the firm’s market valuation? Well, that’s a big question, but as we focus on basic information at this point, let’s first look at the firm’s EV/LTM EBIT (or earning yield) as defined by Greenblatt.

 

Dec-31Dec-31Dec-31Dec-31Dec-31Jun-30Dec-08
2012201320142015201620172017
EV/LTM EBIT (x)N/A62.45.47.414.824.57.4
Earning yieldN/A1.6%18.5%13.5%6.8%4.1%13.5%

 

Considering the earning yields above, it does seem like the stock’s valuation as of today is at least reasonable, especially when considering the business’s growth… There’s obviously a good reason why it’s at the top of the Magic Formula list. However, can the firm’s results stay strong going forward, that’s the question.

Next, what about the company’s Return On Capital? In order to compute ROC, you basically have to calculate EBIT divided by the firm’s invested capital. The denominator will often require some thinking, research and adjustments to your calculations. Interestingly, after doing all the necessary calculations and adjustments for IGG, I ended up with a negative invested capital base which prevented me from calculating a meaningful ROC. This sometimes happens especially with firms generating high amounts of cash which can hardly be reinvested in tangible (or even intangible) assets. By subtracting the cash balances from the firm’s low asset level, this quickly reduces the invested capital base. Most of what a firm like IGG does is to reinvest its cash in its operations and more importantly in its R&D activities. So, looking at PP&E and the intangible assets of IGG won’t give you a good idea of where the money is going. However, even then, the question becomes, is IGG really able to reinvest the money it is generating at an acceptable level. Even if you generate extremely high ROC, if you only reinvest a tiny part of what you earn every year, your money machine won’t work efficiently.

Similar to a company like Amazon, IGG puts back a lot of its cash in its operations and R&D activities, but that doesn’t mean that because these items are considered expenses from an accounting perspective that they necessarily are from a business perspective. For a firm like IGG, these “expenses” are crucial and are made with the expectation that they will generate returns in the future… sounds like an investment to me. Accounting wise, as R&D activities are considered an expense, they are not capitalized and therefore do not increase the invested capital base of the firm, which is one of the reasons why we end up with a negative invested capital amount when trying to calculate ROC.

That being said, as you can see in the table below, when calculating the reinvestment rate of IGG, I decided to include R&D expenses as these are fundamental and represent an important portion of the firm’s expenses/reinvestments.

Although capex and R&D increase steadily, net income varies widely (mostly higher) and therefore the reinvestment rate is not constant. For a smallish company like IGG, the question is, will they be able to keep putting their money to work in an efficient manner and will they be able to increase the amount of cash they reinvest as they grow bigger? I see a lot of companies that seem to have a great long-term future but then, after their first few phases of growth, stop growing as their management team doesn’t have the necessary capabilities to bring the business to the next level. And I think that in this case, this is something to keep in mind.

This preliminary analysis is good enough for a first level filter. The next question is: what should I do with this idea? Kill it or keep digging? Well, to me, it does seem like there is enough here to keep me wanting to know more. It’s not an industry I know very well so I’ll have some homework to do but I’m keen to learn more. Here’s a few risks I will want to assess: 1) the dependence of the firm on specific games and if they have a strong enough team and scale to counter that risk, 2) the competitiveness of the industry and its structure, and 3) if the firm will be able to keep growing and efficiently reinvest its capital going forward, which highly depends on its management team. Let’s see how far I can go into my checklist!

Featured image: You! Let’s do this! Source: clipart-library.com

Embedded image: Castle clash, one of IGG’s games… looks exciting? Source: Company

Next post, next week!

Keep growing your snowball!

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