Investment that People Fondle Admiringly – Part 2

From the last entry, we have discussed and concluded that the China jewelry market still have a sustainable growth potential. When we see a potential investment opportunity, people would generally look at equity investment, meaning stocks, indexes or derivatives from them. They would also put their attention solely on the market leaders. However, from another perspective, market leader does not exactly mean they are the companies or stocks that worth investing. Maturity, from another point of view, means that there are limited growth in either the industry or the company; that also means that there is limited potential growth in the stock price, as stock price and driven by growth. Therefore, investors can perform a thorough and detail analysis on the industry to find the stock that has the highest potential. This time we would use a simpler approach to find stocks that have higher potential than the others in the jewelry industry in China. We have picked a few market leaders in the Hong Kong sales channel and compare the companies on a few different ratios, including the PEG ratio, gross margin, return on equity.

When the stock price rise, the PE ratio would rise with it. To judge if the stock is overvalued or undervalued, one quick way to know is weather the PE is supported by growth. In general, when the PEG ratio is higher than 1, the stock can be classified as overvalue; when the PEG is 1, it means the stock is correct priced; when PEG is lower than 1, it means the market price has not fully reflected the intrinsic value, a sign of buy.

From the PEG comparison table, we can find that, generally, the PEG for the jewelry industry in Hong Kong are significantly lower than 1, the average is 0.29. It means that the industry as a whole is experiencing a relatively high growth. Luk Fook Holdings (International) Ltd. (HKG: 0590) and Emperor Watch and Jewellery Limited (HKG: 0887) are found to have a below average PEG ratio of 0.13 and 0.22, respectively. It means that the two companies is undervalued, basing on their growth.

Besides growth analysis, we must also analyze to check if  the companies price reflects the operation and profitability. Gross profit margin represents the weight of the product cost to sales. Operating margin can tell if the management has been successful with control the cost on administration and operation. Last but not least, net profit margin can help us to see the ultimate profitability of the company.

According to the gross margin, operating margin, and net profit margin, we can find that Luk Fook (HKG: 0590), Emperor (HKG: 0887) and Chow Tai Fuk (HKG: 1929) have both outperformed their peers. From the gross margin, the industry average is 24.21%, with Chow Tai Fuk leading with 29.13%, Emperor following with 28.75%. The result shows that the weight on the product cost for these two companies are relatively lower than the industry. It also represents a possibility that both companies are capable to charge their customers at a premium on their products. However, investors need to beware of the different business models of the different companies, for example, the distribution of the retail stores and the franchise stores in the company.

For operating margin, the industry average is at 10.9% and there are three companies that are found to have an above average operating margin: Chow Tai Fuk (14.44%), Luk Fook (13.37%), and Emperor (13.07%). This says that these three companies are better at controlling their operating expenses, but it could be because these companies are larger corporations. It gives them a lift on utilizing their resources and expenditures better than those that are smaller in size, and turns efficiency into profitability.Under the test of net profit margin (industry average – 8.95%), Chow Tai Fook (11.62%), Luk Fook (11.31%), and Emperor (11.17%) have proved that the very reason for their above average profitability is their better management of the companies. High net profit margin also proves that companies are better at utilizing their financial income and expenses. Due to the low interest environment till 2015, it is expected that the industry as a whole will maintain a relatively high net profit margin in the next few years.

Strategic multiples is another tool to analyze if the stocks price and the target price are supported by the performance of the business model. With the case for the jewelry industry, I proposed to use the gross profit per outlet, operating profit per outlet, and net profit per outlet for the analysis. The industry average for the different multiples are $10,298,000 gross profit per outlet, $4,500,000 operating profit per outlet, and $3,701,000 net profit per outlet. From the earlier analysis, we found Chow Tai Fook, Luk Fook, and Emperor were companies that seem worth the attention. However, after the multiple analysis, we found that Luk Fook has a lower then average in all three areas, but the numbers may not full represent the potential in this company. Luk Fook relies heavily on a franchise model, and it can be the reason why Luk Fook seems less profitability compare with others. Solely basing on the multiple analysis, Emperor and Chow Tai Fook would be the two that worth investing.

At the end of the day, investors care about returns more than any other indicators. The average ROE in the industry is 18.15%, there are 3 companies that has a ROE that is higher: Chow Tai Fook (22.68%), Luk Fook (24.08%), Emperor (18.63%), which shows that they are better at generating returns for their investors. Divided yield averages 2.97% in the industry. Luk Fook lead the industry with 4.66% and Emperor follows its lead with 3.64%. With the using the PE multiple, the target price for Luk Fook is 42.91 with a period of 12-18 months and the total return is 102.9%. The underlying risk of the return would be the expected growth in the jewelry industry in China. Due to the uncertain future in the economy and slow down of economic growth in China, it can be a sign that the industry has passed its super normal growth period. Further research on the macro economy research would be essential for a thorough evaluation on the stocks.


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