Like many investors, I use quantitative screening as a first step to look for opportunites with respect to Benjamin Graham-style cigar-butts and Warren Buffett (Trades, Portfolio)-style wide-moat compounders. But I am cautious not to end my analysis there. Two stocks: Wotif (ASX:WTF, Financial) and Lianhua Supermarket (HKSE:00980, Financial), which I have looked at recently, validates my view that screening should not be an end in itself, unless you stick to a portfolio approach of wide diversification.
Hong Kong-listed supermarket chain
Lianhua Supermarket operates supermarkets, hypermarkets and convenience stores, primarily in the Eastern Region of the People’s Republic of China. A quantitative screen revealed that it was trading at close to 160% of net cash (cash – interest bearing liabilities).
But Lianhua isn’t the bargain that its cash position suggests. A closer scrutiny of Lianhua’s balance sheet revealed 3.3 RMB billion of coupon liabilities, not included in the earlier standard net cash calculation.
Note 34 of the Annual Report mentions that “The Group incurs coupon liabilities when coupons are sold. Coupons redeemed in exchange for products of the Group during the year are recognised as sales in the consolidated statement of comprehensive income using the coupon sales value. Certain coupons redeemed in exchange for products or services of other retailers which have agreements with the Group are settled and paid to these retailers after deducting the Group’s commission based on the agreement.”
Essentially, Lianhua has sold coupons to its customers for future redemption and deposited the cash collected in the bank to earn interest income. Therefore, its cash balances don’t reflect free cash flow generated from past sales, but future obligations that have to be fulfilled (and offset) when customers use its coupons for purchases.
Deducting coupon liabilities from the net cash position, Lianhua is no longer in a net cash position. This is illustrative of the perils of a pure quantitative approach.
Australia-listed online travel company
Based on quantitative criteria alone, Wotif, Australia’s leading online travel booking services company, will meet the definition of a wide-moat compounder. It has maintained positive free cash flow and ROICs in excess of 50% in each year for the past eight years. Having seen its share price fall by 50% in the past 52 weeks, Wotif now trades at a mere 5.2x trailing twelve months EV/EBITDA and 11.4 times trailing P/E.
However, there are two reasons why I will stay away from Wotif, despite its apparent cheapness.
Firstly, given the global nature of the accommodation business, Wotif might be giant in local in terms, but is small compared to new entrants to the Australian market such as Expedia and Priceline. Since scale plays a critical role in the strength of the network effect, Wotif faces serious competition. Also, Wotif’s suppliers, the hotels, have incentives to wish for more competitors, as they will prefer to have multiple listings and increase their bargaining power with Wotif with respect to commissions and payment terms.
Secondly, Wotif’s strong free cash flow has been driven by its negative working capital model, where it receives cash for bookings from customers before paying hotels or airlines (suppliers). But negative working capital only works if revenues are growing. It’s worrying that Wotif only increased its revenues by a cumulative 11% for the past five years. As Wotif’s growth stalls, it will have to pay suppliers from cash on hand and cash flow will shrink. It runs the possibility of short- term liquidity issues if it doesn’t have cash to fund the shortfall.
Finding real cigar-butts and real wide-moat compounders
I take the analysis of cigar-butts and wide-moat compounders one step further, after the screening process. For cigar-butts, I stress-test the accounting values of assets on the balance sheet and hunt for hidden off-balance sheet liabilities. With respect to compounders, the sustainability of economic moats and the availability of opportunities within the moat to reinvest excess capital are two criteria that I look at.
