Hi all,
Just wanted to put in my perspective on Eratat using a fundamental focus based on a financial/management approach.Note that there are many other companies out there which are undervalued too.
However, I hope to point out that one of the key reasons why I'm vested in Erarta is precisely because of what newbiestock mentioned: The sense of asymetrical information and opinion bias across investors.Without information and opinion differences, the semi-strong market hypothesis would rule - and all companies would be more or less correctly priced at all times.
However, the semi-strong market hypothesis is a farce when it comes to small caps (despite it being taught at the University level). However, it's a fundamental benchmark which many use and it's something that is the best in class (how sad that the best in class is something that doesn't work well most of the time). The problem isn't about the semi-strong market hypothesis, but rather that it CANNOT be applied to
(1) a set of stocks where the broad market is not interested in (most of the liquidity and interest will follow the blue chips and companies with a larger market capitalization). - Support: Statistical (if you actually base it on market liquidity numbers)
(2) In addition, the analyst reports on small caps tend to be of much lower quality (I mean, if you are a firm, would you put your best analyst covering the blue chips or the small caps?). On top of that, Analyst covering these small caps might not even want to put in as much effort (Would you? if you were tasked with covering stocks that aren't seen as important to your colleagues?). - Support: Human Psychology based on Cognition and Cognitive Dissonance Theory; Economics - Transaction Cost Economics Theory.
(3) There is asymetrical information with regards to these companies because they are not covered as well most of the time (see point 1 and 2 for the rationalization). In addition, most small caps tend not to give information that is as rich or meaningful given their size and resources (although the standards have been increasing remarkably and this difference might get reduced - e.g. with SGX now getting small cap firms to publish reports on a more regular basis. Saying that, small cap firms still tend to underpublish reports and market related information) - Support: A scan over the published reports of companies on the SGX site will show you a strong correlation between size of firm and published reports.
There are actually a number of other smaller factors that influence why the semi-strong market hypothesis does not work for small caps... but I will not go into detail here. Just to mention some of them - (a) Corporate governance is weaker in general for small companies, leading to differences between private knowledge of insiders and selected individuals, and shareholders (the public), and (b) A lack of resources to develop control systems and to articulate control measures, etc to the public.
If the semi-strong market hypothesis doesn't work well for small caps, then why are so many individuals using it to try to judge value of the company? I believe that's where the difference between the believers of Eratat and the sceptics of Eratat lies.
From my observation of the points mentioned in the forums, the sceptics point towards all kinds of issues (e.g. receivables increasing, new orders being lower than the year before, etc)... and say that given the current price, these news should lead to a reduction of share price, etc. What they fail to recognize is that the current price is not an accurate base because it has accumulated a discount bubble over time. (It's similar to double or triple discounting the same issue, leading to an undervaluation). This happens because it is done over a period of time, instead of doing a fresh analysis at a given time, and adjusting the discount factor accordingly).
How then should we analyse Eratat then? Well, My approach is to do an analysis that is causal in nature, based on the fundamental drivers of value. Primarily, these would be:
(1) The ability of the firm to generate positive sales (i.e. sales that add to the bottom line - thus including a cost component intrinsically) - Eratat does this very well... with overall sales increasing significantly over a sustained period of time (I'm talking trend here, and not variance between various quarters). in addition, the margins of their products have been improving as they move up the value chain. This will likely run out of steam over time (first (a) the margins will run out of steam, then (b) the ability to generate positive sales (not just sales)). However, there's so much room to grow that (b) will run out of steam in the distant future if Eratat does it right, and (a) will last longer than most expect because Eratat has just mvoed into the Premium product, so product mix has room for improvement still. In addition, as they gain clout and bargaining power, margins can improve from a costing and distribution perspective. Improvement of branding over time (and brands are something that takes time to build up) will also lead to the ability to generate positive sales.
(2) The actual asset backing of the firm (current and potential) - Well, Eratat has a good backing at the moment. However, it's a small backing. As such, one of the risk they face is over-expansion, because that can actually dilute their backing per (fill in the relevant measurement unit you want to use here). Effectively, what this ratio means is that for every key measurement unit (e.g. store), they have a certain asset backing. Normally, a minimum asset backing is required to ensure sustainable growth and to cover any external shocks that might occur. Think about it as insurance and the limited use of leverage. If Eratat expands too fast and run into bad distributors or something, they might really be in deep trouble. However, my reading is that this is not a problem precisely because of what they've done. (a) They're trimming their distributors to reduce the risk per distributor/store, (b) They've controlled their expansion in a manner to make it more manageable and sustainable, instead of rushing to open stores and using more distributors, (c) They've focused on quality, not only in terms of product, but distributors and relationships between the company and core related players (mainly suppliers and distributors) - This includes the subsidy for their classic stores. Effectively, the routines used and articulated help show that Eratat is planning to grow in a sustainable manner that reduces risk.
With (1) and (2) being positive for Eratat, it creates a strong fundamental base. However, having a strong fundamental base isn't meaningful for the investor. The stock must still be undervalued relative to this base (and for that, I have to thank the sceptics)
To determine undervaluation, we need to now look at the proxy ratios (NOTE: PROXIES... but these are based on the fundamentals described in 1 and 2).
(3) Earnings is estimated at 8 cents for FY 2011. From here, you can use PE, etc
(4) Liquidity Ratios like the acid test ratio is very good. (I will not do an actual calculation here, but I have looked at the Balance Sheet and you can do one yourself). Other useful ratios relavent to this would be your NTA per share (and I ALWAYS EXCLUDE goodwill for my calcs).... so NTA NOT net asset. It's safer.
(5) You can also look at growth on a yearly basis (since fundamentally, value is a function of current value of the firm plus future value - or a forward estimation of income stream).
Just using 3,4,5 (you can add your own here), we get a firm where its asset base is way higher than it's share price. In addition, the earnings it generate is so high, then it can cover share price in less than 2 years. So, we've established that Erata is CLEARLY an undervalued stock... with good fundamentals.
Now that we've etablished that, it's still not all clear. You'll have to determine if WYSIWYG (or what you see if what you get). Eratat is an S chip and the S chips have had a bad reputation... and rightfully so (except that that's again a flawed assumption, despite it being "rightfully so). I'll explain here, but it's another long analysis and explanation, so I'll save it for some other time when I'm feeling the "itchy fingers" syndrome) - or you could hire me as a consultant and I'll spend all my time explaining stuff to you. hahaha.
Anyway, to determine WYSIWYG, we need to look at how trustworthy the data they're providing is, their corporate governance, etc. Doing a quick analysis on this area, I've come up with this:
(6) Corporate Governance - well, they've done very well in this area, as documented by their rankings, especially among S Chips. A side note is that a lot of management is Singaporeans (which does make me feel better than if a lot of management were Chinese). I'm not being bias against the Chinese, but the institutional environment where one grows up in does affect this area. Support - check out Institutional Theory - both economic and sociological (read on mimicry and isomorphism).
(7) Communications (Truth in intention) - Eratat has tried to communicate with its shareholders at multiple points to explain their story. This gets touchy because the sceptics will say that "there's a reason for anything"... and I have to agree with the sceptics. You have to take everything with a pinch of salt and keep your eyes open. However, you can try to piece their story together and figure out if it's a lie or truth. Such skills are actually taught in the US and used in police forces, etc to determine if someone is lying or not. Some people call it instinct. However, a more statistical approach is to determine the crombach alpha of the various statements being made after grouping into relevant categories (or constructs). From there, you can test for the strength of the relationship. In this case, too high a crombach alpha (WITHIN the same category) can signify lying, because the story is too perfect. On the other hand, too low will also signify lying. Comparing it ACROSS categories, a lack of fit would signify lying and good fit will signify truth. Now, this approach is conceptual and if someone actually tried to do it this way, it'll be extremely tough and given the realities of the world, quite infeasible. My take on Eratat - They seem to be making statements that are true and honest in general. Statements made over time and across components (e.g. their stated strategy, their receivables story, their distributior story, their subsidizing story, the finanicals, their cashflow, their dividend policy, etc) seem to suggest that it is truthful... despite having some issues. The issues make it more believable in my opinion, although I'd rather have slightly more capable management to reduce these sources of friction.
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Believing their Books - The last point which I will bring up will be whether we can actually believe their books. Have they actually cooked up numbers, etc. This is normally INCREDIBLY difficult to determine. Fortunately, for Eratat, we have 2 big thing in our favor - (a) They're a newly listed company... which means that we can follow thie cash, etc since inception as a public listed company, and (b) They operate in a highly visible industry. If we only have 1 out of the 2 points, it would be difficult to ascertain whether their books are clean, because it would be very opague (over time, it's easier to hide sruff under years of information, and if there's no visibility of what hey do, then it's also easier to hide stuff). Either way, we know how much cash they've raised, and we can see where that cash is going into. Some of the forummers have done estimations, etc... and the overall feel is that the money can be tracked quite nicely. In addition, Eratat does provide with margin numbers, etc.. and those seem to make sense. They also do follow a dividend policy despite growing. This is in line with they approach of sustainable growth, and a signal to show that what they have on their balance sheet is real.
After doing (6,7 and
, I've come to the conclusion that Eratat is a fundamental sound company that is very undervalued, and the risks of a default based on some endogenous event (such as corporate fraud) is relatively low.
That's my very hefty 2 cents. What's your take?