‘Qualitative Value’ of Stocks

As an investor, I regularly read the Berkshire Hathaway Annual Letter written by Warren Buffett, which usually published in January or February each year, to gain a lot of investment wisdom directly from Buffett himself. In the latest edition of 2014, Buffett shared his experience when acquiring See's Candies, a manufacturer of candy, sweets, and chocolate, in 1972, which after a few decades later, this investment successfully generate huge profits for Berkshire.

Buffett acquired See's on the advice from his partner, Charles ‘Charlie’ Munger, who introduced a new investment strategy that Buffett has never been apply it before, namely: Buy a wonderful company at a fair price. Previously, since 1950, Buffett almost always bought stocks/companies at a lowest possible, for example at a PBV of less than 1 times, regardless of whether the company has a good fundamental or not (and usually, you can buy stocks at a ‘wonderful’ price only if the company itself is a terrible one). And although the strategy was mostly successful, but Buffett often stuck in a position as the owner of a company that continues to lose money.

Meanwhile, when Buffett had the opportunity to acquire a 100% stake in See's Candies, a wonderful company which promising sustainable profits in the long-term, but the opportunity must be redeemed at a relatively high price, where Berkshire have to pay US$ 25 million for a company with equity of US$ 8 million only, or in other words, with PBV of 3.1 times. Just for comparison, when Buffett bought shares of Berkshire Hathaway for the first time in 1962, its PBV was only 0.4 times.

But apparently that Buffett’s investment in Berkshire was a total failure, in which he had to shut down Berkshire’s last textile plant in 1986 (and Berkshire Hathaway then transformed into a holding company). While his investments in See’s? It was a great success, and it still is. Until today, See's Candies remains one of the most profitable company owned by Warren and Charlie.

And this is the interesting part: In his annual letter, Buffett said that from See's Candies, he learned that intangible assets such as reputation, the power of brand, and the competitive advantage of the company, are far more valuable than tangible assets such as factories, inventories, etc. Yup, See's Candies was a legendary chocolate in a box maker with strong reputation and history, but these intangible assets weren’t stated in the company’s financial statements, because it can not be measured in US Dollar. So even though the See's purchase price of PBV 3.1 times seem expensive, but remember that the price is based only on company’s tangible assets, and not taking into account the value of intangible assets. If Buffett found another chocolate company sold at a lower price, for example at PBV of 1.0 times but the company had a bad reputation, its product’s brand were unknown to the public, and had no competitive advantage, then Charlie would still recommend to buy See's.

Value of Intangible Assets: Qualitative Value

In value investing, as I have had mentioned many times before, there are two tasks of a value investor: 1. Selecting the stocks/companies based on fundamentals, and 2. Determining the purchase price for selected stocks. For the first point, sometimes investors only look at indicators that can be calculated/have numbers, aka quantitative values, such as the value of equity, the percentage increase in net income, return on equity, profit margins, and so on. While indicators that can not be calculated/have no number, aka qualitative values ​​such as the power of brand, etc., it has a greater contribution to the fundamental value of the company as a whole, because it is more difficult to be obtained.

For example, to build brand strength, every company must pay for the advertisement. But does the greater advertising budget mean the better popularity of the brand? Not necessarily. Wings Food, the maker of instant noodles with brand 'Mie Sedaap', whose ads appeared on television almost every day, but nonetheless the popularity of Mie Sedaap still can not beat Indomie, the most popular brand of instant noodles in Indonesia, which already entrenched in society.

From Buffett’s writings about See's, I understand why the shares of certain companies such as Unilever Indonesia (UNVR), Bank Central Asia (BBCA), Indofood CBP (ICBP), until Kalbe Farma (KLBF), they are priced at high valuations compared to average valuation of other stocks, because these companies have almost everything beyond their tangible assets, such as reputation, brand strength, credible management, until their status as blue chip stocks. Although, if the company experienced a drastic decline in its financial performance, its shares will also go down, such as the case of Multi Bintang Indonesia (MLBI), one of the most expensive stocks in the IDX, but as its profit dropped for the first time in 2015, the stock also went down.

But on the other hand, as long as the financial performance of the above companies are still growing, the stocks will continue to rise, or at least not fall, even though its PER and PBV were already very high.

The problem is, because these qualitative value is of course have no numbers, it is relatively difficult to ‘calculate’ the value. For example, if you live in urban areas, Bank BCA may have better brand strength, that its ATM machines can be found almost everywhere. But for people in the village, perhaps Bank BRI is much more popular. And this is different from quantitative values such as return on equity (ROE), whereby if a company has a ROE of 20%, it is clear that the deserves a higher valuation, compared to other stocks with ROE of only 10%. In this case the qualitative values ​became ​subjective, where your opinions that a company has a good reputation could be wrong, if the majority of other investors think that the company has a bad reputation.

But in practice, it is actually not that hard too. For example, when you consider about of ‘quality management’, then which one would you choose? The stocks of Astra Group’s, or Bakrie’s? You surely know the answer.. And here is another example in the field.

Applications

After reading the annual letter of Berkshire, I slightly change the strategy: Some stocks with PBV of 4 or even 5 times are still worth to buy as long as the company has a high qualitative value, of course, by still considering the quantitative values ​​such as ROE etc.

And after looking at the fishes in the pond, I select Jasa Marga (JSMR). Earlier, I never glanced at JSMR because of its PER that is always above 20 – 25 times, or even more expensive than Bank BCA. But after reading my own article about JSMR in here, I realized that JSMR has many qualitative value that does not exist in other companies, such as the popularity of the company (who do not know Jasa Marga?), a business model that is secure for the long term (toll road), the good quality of GCG, until the good track record of bond repayment.

When the article was written in February 2014, JSMR was in a position of Rp5,000 per share, had dropped quite far from its peak of 6,900. But after seeing that even at the price, JSMR was still expensive, then so be it, I did not bought it. But later JSMR continue to go up until reaching Rp7,000 per share in January 2015, or gained 40% in less than one year, which left me confused (but then I found the answer in the annual letter of Berkshire).

Entering April 2015, the Jakarta Composite Index (JCI) began to fall, and so did the JSMR, which in September 2015 it finally back to the price of 5,000. And this time I did not waste the time: I directly buy JSMR! The result, though JSMR had dropped further to 4,500 in last December, but it later rose again and, when this article was written, it was traded at Rp5,800 per share.

Although we certainly can not predict the movement of JSMR (and also any other stocks) in the short term, but one thing is clear: This company has qualitative values, and that’s why it is worth a higher price than stocks of companies with the same ROE, etc. The same principles apply when we in August 2015 discussed Nippon Indosari Corpindo (ROTI), which despite its PBV of 5.2 times and PER of 22.3 times at the price of Rp1,085 per share, but I said that that price was quite reasonable. And indeed, until now ROTI is still not moving anywhere but in the range of 1,100 to 1,200.

So from now on, beyond quantitative factors such as the value of equity, ROE, profit margins, etc., you can begin to consider these qualitative factors in assessing the fundamentals of a company, and also what is the decent price/valuation for their shares. Including, if you find a stock with a valuation that seems very, very low, then try to check it once again: Does the company have a qualitative value? Because if the company did not have a qualitative value at all, then carefully, the valuation may not be as low as it seems because, again, the qualitative values are more valuable compared to what appears in the financial statements. And be careful: As well as financial performance, the value of brand or the reputation of a company can also be dropped at any time, for example when there come a competitor with more popular products. So, just as we need to check the company's financial performance from quarter to quarter, we also need to evaluate the qualitative values of companies every once a while.

Okay, I think that's enough. Next week we will discuss a little about the price of oil, and its impact on JCI.

Any inquiries about investment in Indonesia Stock Market, please send an email to teguh@averepartners.com