Downside to Value Investing?

The story

The controlling shareholder, Wong's Brothers, decided to delist Tsit Wing at an offer price of 27 SGD cents. The rationale behind the delist is due to poor interest in its stock (low market valuation that does not reflect its worth) and to facilitate restructuring by easing capital investment into the business as a private status.

Downside to value investing

Entering my 4th year of investing, I finally experienced a downside to value investing - voluntary delisting of an undervalued company. I have myself to blame (or at least someone, or something to blame) if I wrongly valued a company and overpay for the business. I will be glad to analyse what went wrong and avoid making similar mistakes.

But when a company is to be delisted just because its value is not recognised (that's precisely the reason why I invest in it), then I really feel like banging the wall all these years for nothing.

Delisting unvalued firms not equivalent to value trap

I must stress here that such misfortune is not tantamount to a value trap. Value trap occurs when an investor overpays for a business with the wrong assessment that it is undervalued.

The risk

Thus I just realised another risk of value investing - voluntary delisting. Though I did not suffer any loss on Tsit Wing, in fact I made a meagre profit of a few hundred dollars after factoring the lucrative dividends all these years, I am obviously not please to make a few percentage gains after these years of patience - the ROI is too low!

Lesson

I pondered with the idea of not investing into companies with low liquidity and/or those whose controlling shareholder holds a unfair majority, but after cooling my head and thinking it through, I rejected this idea.

Firstly, one common attribute of an undiscovered gem is low liquidity. If many know about it, the volume will not be so low and the potential upside (or rather the margin of safety) will not be so high.

Secondly, even if the majority shareholder does not delist an undervalued stock, there is no stopping them from selling the business if an offer is deemed good enough.

Conclusion

I can only control what I can control. Those that I can't, I leave it to my two trusted aides, margin of safety and diversification to help me.

I bought CH Offshore on 25th May 2009

Before I go into the rationale behind my purchase, I will like to share some thoughts on the oil & Gas industry (from the investment context) and value investment in general. I had quite a fruitful discussion on the above topics in one forum thread and exchange of comments with a reader on my blog entry when I purchased SPC.

Oil & Gas Industry from an investment point of view

The first thing that came to mind when one discussed about the industry is crude oil price. As far as investment is concerned, unless one buys a crude oil index exchange traded fund (ETF) or equivalent, using crude oil price as an indicator is not so straight forward.

The meaning behind crude oil price

It is quite easy to miss the forest for the trees. Once the crude oil price surge, the immediate sentiment is that oil and gas industries must be making money but this is not so. Crude oil price is just a barometer for supply and demand. Whether emotional, speculative or real, it just signifies meeting point between them. And it is that simple.

Oil and gas activities can be divided roughly into 3 categories:

1. upstream (oil and gas exploration and production)
2. downstream (crude refining)
3. support (offshore support, rig manufactures etc)

When real or anticipated demand exceeds real or anticipated supply, oil price surges and vice versa. The movement of the supply and demand curve moves the crude price and had varying effect on players in the above 3 broad categories. Note that demand and supply curve (whether real or emotional) must move first before crude oil prices barge.

Upstream

Players in oil & gas exploration and production players are the first to benefit when price surge and first to suffer when price plunge (especially so when price plunges below production cost, i.e.

Profit = function (crude oil price)

Downstream

Players are mostly refiners who use crude oil as raw material and sells refined products. Their profit are heavily dependent not on crude oil price, but crack spread (the profit margin between crude and refined oil). Most of the people I talked to focus on this, but that is only part of the picture. The next part is demand. Profit is a function of sales volume and profit margin:

Profit = function (crack spread, sales volume)

Downstream players are more sensitive to crack spread and sales volume rather then crude price. When economy is booming, the demand for crude generally rises (emotionally or real) more than supply can keep up. The effect is rising prices. The crack spread might suffer, but profit can still go up if the increase in sales volume more than make up for the declining spread. Problems arises when the crude price surges to a point that affects demand, then both sales volume and crack spread drops and hurt profitability. It is these dual factors that gave people the wrong impression that profitability of refiners had nothing to do with crude oil price. It does, but indirectly via demand and supply curve instead.

Support

Support players are very much affected by crude prices but lags crude price cycle a big deal. When the economy starts booming after a recent recession, it will take some time before demand catches up again with supply. It will take even longer before crude price surges again to a point that makes oil and gas exploration or extractions lucrative. Further lengthening the cycle is that support projects typically have long gestation periods. It takes many months to build support vessels or oil rigs and sustained efforts during exploration. Activities can persist for months after oil bubbles burst.

Actions

Thus, once the euphoria for oil and gas industry subside with the collapse of the oil bubble, I believe there are opportunities to look for bargains. First, I bought SPC, now I bought CH Offshore. The former is a typical refiner (though it has some exploration and production segments) and the latter is a typical support player. Compared to other companies (such as Ezra and Swiber) operating in the support segments, CH Offshore stands out with its less (nearly none) leveraged business model. The downside is its growth will not be as speculator during the upturn. I could have got it way cheaper a few months ago, but alas spare cash don't come easy these days.

A few words on Value Investing (and fundamental analysis)

From the forum discussion, it becomes apparent that some believers of value investing would ignore cyclical businesses because they find them hard to value. Value investing preaches buying things below their intrinsic value with sufficient margin of safety. Intrinsic value is an estimate. Just because cyclical businesses's intrinsic values are difficult to ascertain due to the highly fluctuating profits and losses does not mean value investing cannot be applied.

Look at it another way. Highly cyclical businesses have such huge peak to through fluctuations in earnings (and hence share price) and these fluctuations are recurring in nature. Hence, the magnitude in the fluctuations safely assumes that purchases near the through when a cyclical sector collapses (not price bottom since one cannot predict the bottom) should provide the sheer margin of safety.

It is for this reason I bought Courage Marine when BDI crashes below 800 when I believe the shipping bubble had more or less burst.

Conclusion

There are always many routes to a destination. Some are more established while some are less travelled. By sticking only to the established route, one misses out the many hidden opportunities that could have been better.

Matrix for Personal Finance Planning

Rationale

As I was working on a long term planning project, I came up with a matrix to put various initiatives in perspective. It suddenly dawn on me that I could apply that matrix I developed to personal finance planning. I promised my friend to blog on it, so better keep my promise :).

Personal Finance Planning Matrix


The above shows the personal finance planning matrix I've created for a typical, non-financially independent individual like myself, still slogging to make ends meet. Basically, annual income can be spent or set aside for future use. Spending is typical a reaction to a need or want and hence 'reactive' versus saving where money is set aside for future use, i.e. pre-empting future rainy need.

Risk provides another dimension to consider when spending or saving. Merely spending on needs make life boring and meaningless while merely savings lose out to inflation. Thus inducing the individual to pamper oneself with some discretionary spending on wants. For the more adventurous, dabbing in some investments for higher returns.

Self-profiling

Before one consider how much to spend, to save or to invest and much is enough, how much is too much, one could consider using the matrix above to put things in better perspective. The following shows a annual budget profile for an individual, drawing some 14 months salary during a typical, non-recession year:


By looking at his or her profile, one can easily come to conclusion whether he or she is comfortable with the distribution, in terms of months of annual salary actually used in each section.

One potential contention or confusion is differentiating between 'need' and 'want'. Since each individual have different value system (i.e. what is important to one may not be important to another person), differentiating between needs and wants need not be a painful exercise, just allocate things one can do without into wants.

How much is enough?

To answer the question of under or over allocation in each section, one can take a stock of his or her current status:

The above chart assumes an individual currently had 6 months of savings and 12 months worth of investment (current liquidatable value equates 12 months of gross salary). Thus in times of crisis (loss of job or can't work), he or she can easily survive more than a year (assume investment value plunges by about 50%). But is this enough? With his or her financial profile visible now, it is up to the person to decide. e.g. "am I comfortable with 6 months savings?"

Setting a target

One can now set a long term, say 10 years, target of his or her financial position:

By saving only 2 months of salary (and not spending from that pool of funds) and investing only 1 month salary, the accumulated pool amounted slightly over 3 years (assuming investment give about 5% annual returns).

Assuming the individual is not satisfied with the above 10 year situation, one can easily set a comfortable target in terms of accumulated savings and investment and work backwards, invariably having to spend less and save/invest more.

Where to place insurance?

A few (several) words on insurance before I close this article, I see insurance as a service to help one take care of unforeseen financial consequence one is unwilling or unable to afford. Thus if it is a service, it must be an expense. If such a service is a need, then it should go into the 'needs' spending section. However, one point of contention arises because today's insurance products are typically very much convoluted with investment components. Investment is a pre-emptive product meant to generate returns for the risk involved.

The fact that many life policies provides insurance coverage (expense) yet provide surrender value above total insurance premiums paid over the years (returns) once the policy matures, depends heavily on investment returns that is far from certain. The underlying assumption is that the investment component of the life policy generates sufficient return to cover insurance expenses (insurance company's expenses + insurance agent's commission) and insurance premium paid by the person assured. When the investment component does not perform as well as planned, the assured will be quite disappointed to learn his or her policy have not 'break even' after paying the premium for decades. It would have been better to separate the two, i.e. buying term policies and investing the 'excess' premium separately.

In conclusion

It is quite difficult to plan one's route or know where one's going without a map. The matrix above provide such a map to locate oneself, and the destination one hope to go, and plan the route accordingly. Charting for myself, I'm happy to see my current location and see that I'm going in the right direction. Hope this is helpful for you too.

I bought Soup Restaurant on 4th May 2009

Rationale and Action

This is the first time I bought something not for investment, or rather, investment is not my primary concern. My wife like the food very much and I just came across its announcement on 30th April 2009 about Shareholder privilege card scheme, i.e.15% discount for shareholders with at least 2 lots.

Investment grade?

As for investment assessment, I have my reservations. Unless it have a strong franchise potential (which I can't see), I think it'll be like any other restaurant business that will have difficulty generating sufficient value above cost of capital for shareholders.

More on the card

To get the discount card, one need to fill a form to proof ownership of at least 2000 shares by disclosing ones' CDP account number. I presume they'll check it there. However, once I get hold of the discount card, I can't think of a way to verify I'm still a shareholder the next time I dine at Soup Restaurant. The staff at Soup Restaurant can't be checking with CDP everytime a customer produce that discount card right? So what is stopping anyone from buying 2 lots, get the card and sell it off?

Conclusion

This post is short. This blog is my diary so might as well pen this down for future reference. Anyway, I got hold of some 12 lots just in case Soup Restaurant proof me wrong and is able to create more value than I think possible. Look forward to my privilege card :)

First Ship Lease Trust's Distribution Reinvestment Scheme (DRS)

DRS Summary

In short, DRS is a scrip dividend scheme for FSLT to make payments through issuing new shares in place of cash. FSLT had 2 strategies to reduce cash payout in terms of dividend, one is via direct reduction in distribution (from almost 100% to 75%) and second is via DRS. While a 25% cut in direct distribution conserve about USD 4m, how much DRS can conserve depends on the take up rate, up to a potential conservation of about USD 12m. To entice shareholders to take shares instead of cash, the shares are offered at a discount of about 5%.

Shares or Cash dividend?

I had an enjoyable discussion on the topic with a reader and the our correspondences (via comments on one article) can be found here. After the fruitful exchange with better insight, I summarise the key points and add a few more.

Qualitatively, if the market ultimately recover (before 2012 when the first bullet payment is due), choosing shares might seems a better option. But in current market sentiment where cash is king, many might choose cash that is immediately tangible. If the shares crash further, the cash can buy more units than those offered at a discount under DRS.

Those who should know better

Is there other hints for a better decision? The management and the sponsor should hold the key to the answer, if they don't know, who would know better? Along with the annoucement on the discounted price of the new shares under DRS, the take up rate of the key directors and sponsors are disclosed as well. If all of them subscribe 100% to new shares, I would almost do the same without much thought. In contrast, if the unamious choice is cash, I'll take cash and run fast. However, shareholders looking for a mark of confidence is still disappointed. The key directors take up 100% while the sponsor choose only to take up the 25% of the distribution in shares. 'Insiders' show their confidence, sponsors shows their reservations.

Quantitative Analysis

So qualitative analysis doesn't help here. How about quantitative analysis? The following is table tested the outcome if I choose shares entirely while 25% of other shareholders choose shares.


Under this scenario, my dividend entitlement for the next distribution will rise by about 7.2% to compensate me for taking shares instead of cash now. This compensation will fall to a meagre 2% if all shareholders take up distribution in shares. (Note that the actual DPU falls by 2.5%. The fall is even larger at 7.2% if all choose shares).

Over a longer period, until 1Q 2012 when the first bullet payment is due, the comparison for taking shares all the way versus taking cash all the way is illustrated:


Here, I assume the DRS only applies until 3Q 2010 when the USD 65m tranche is due for first installment (the distribution cut to 75% should be enought to service this installment) and dividend continues until 1Q 2012 when the 1st bullet payment is due. It is quite clear that taking shares might be a more worthwhile option, provided the shares are still worth something by 1Q 2012.

Benefits to FSLT

I've been talking from common shareholder's point of view. How about from FSLT? Cutting distribution to 75% generated about USD 4m and assuming all shareholders take up shares, will yield another USD 10m (the sponsor already pledge to take up 25% distribution in shares). But against the loan of some USD 500m, it might seems meagre. Noting that one of the value-to-loan covenant is 145%, a USD 10m reduction in debt will improve value-to-loan ratio by about 3.5%. But the expected reduction will be much lower since I don't think most shareholders will opt for shares.

Conclusion

I'll take up shares for now and see how other shareholders react. In the long run, I'm still confident that if the management can make use of the (slightly) better financial position to improve distribution in the future (via more distribution accretive acquitisions), it is still better to take up more shares.

I bought Singapore Petroleum Company on 27th March 2009

Rationale

Ever since the crude oil prices hit around US$ 30 sometime ago (from a record high of above US$ 140 last year), I believe the business fundamentals for oil companies (e.g. SPC) have made a U-turn.

There are a two main sources pressuring their income statement:

1. Inventory write down (declining oil prices)
2. Declining revenue (from falling demand and refining margin)

Given the speed at which crude oil prices had collapse by Dec 2008 (around US$ 40), the inventory write down should more or less been completed by the last FY report, ending 31st December 2008.

While demand will take some time to recover, the downside will be limited given current widespread dependence on crude oil for basic subsistence.

I could have bought it earlier, when SPC share price languish slightly above $2, but spare cash is a rare commodity nowadays and it is only recently that I am able to scrape enough to buy some.

Potential for more inventory write down

Oil prices trends

The following is the crude oil future contract compiled from Energy Information Association:


For a relatively long time in modern history ( 1986 to 1999), the world seems contented with crude oil around US$ 20. Assuming an inflation rate of around 3% to account for rising living standards (greater convenience in life centred around electricity use and motor transport) and adding another 1% for world population growth, the resultant stabilised oil price is still about US$ 30 (9 years from 1999).

Cutting supply to boost prices?

The following chart is also compiled from Energy Information Association:

Despite a few relatively small crisis, Asian financial crisis in 1997/98 and SARS in 2002/03 (compared to the present) from 1997 to present, there was no notable cut in supply even though prices took a sharp dip (see oil futures chart above) in both periods. In fact, supply continue to grow steadily over the years. Cutting supply to boost income doesn't really make sense unless the surge in price is sufficient to offset the (promised) plunge in volume. Since the volume normally does not drop as much as promised, the price is not boosted as expected. On the contrary, if demand continue to drop, the oil producers instead have to increase production to sustain their income, more so in a bearish oil market.

Taken together, the potential inventory write down in coming quarters is still material but not as significant as when the crude oil price was above US$ 100 per barrel.

Declining revenue

The following charts is the refining margin published by BP, annual average and weekly average respectively:


Given current volatility in crude prices, margins are volatile as well. But generally, on a broader scale, as crude price stablise and demand falls back to earth, a margin of around US$ 2 to 3 should not be too much to ask for. When refining margins were that low (2002, 2003), SPC's downstream activities could still deliver about SGD 30 to 50m operating profit (or about 1.5% operating profit margin).


Upstream activities

Perhaps, the only cushion to the declining revenue (and profit) from the downstream activities is from the exploration and production (E & P) activities. However, with a sharp drop in crude prices, the contribution from E & P will also drop drastically compared to 2008 but still higher than the downstream activities.

Risk

The only risk I can see (other than oil price collapsing to zero and people stay indoors to burn candles) is the hedging activities carried out to hedge against oil price exposure. Despite stating that the SPC adopted a prudent risk management policy, unexpected high volatility in oil prices can render such activities useless and even implicit damage to the income statement.

Conclusion

Not too long ago, when oil price was aiming for the moon as it surge to US $147 per barrel, all sorts of infrastructure investment was launched to increase production. Now, as the price crashed back to earth, many investment was scrapped (also due to the ongoing credit crisis) as the projects are not justifiable at current crude prices. Thus setting the ground for future supply crunch again. Anyway, as fundamentals reach or about to reach a turning point, its about time I collect some for the future.

Yield Investing versus traditional Value Investing

Motivation

No one doubts that the current economic crisis is one of the worse the world experience since the great depression in the 1930s. However, the silver lining is that it brings one of the greatest investment opportunities too. I remember $20,000 is not even sufficient to buy one lot of DBS or UOB, now this same amount can buy one lot each of DBS, UOB and OCBC (with some to spare if not because of the rally on friday).

I had wrote before that market price always lag (not lead) fundamental changes. Even though stock market are generally forward looking, and can stage a sustained rebound months before the real economy turn around, fundamentals must improved first before that happens. But I have yet to see any improvement in fundamentals. Many companies, across varying industries, are either seeing substantial drop in profits or making losses (due to heavy overheads or intangible asset write-downs).

Thus, other than waiting and grabbing shares of firms going way below their (deteriorating) fundamentals, is there any alternatives?

Yield Investing

I began to toy with a new the idea after I bought in First Ship Lease Trust (FSLT) and Cambridge Industrial Trust (CIT). Despite the volatility (generally downwards) of their share prices and that of other shares in my portfolio, both paid generally consistent and substantial dividends. I recall my target cost of capital was about 15% compounded annual returns, so that I can double my investment approximately 5 in years. Both could easily exceed this expectation solely on dividend payout (even after factoring reduced payouts).

Given the uncertain economic outlook, spare cash might not be easy to come by as I need to set aside cash for more rainy days ahead (thus no longer money I can afford to lose). My source of funds to grab bargains shrunk substantially as a result. Fortunately my quarterly dividend income come in nicely to fill the gap.

As a result, why don't I increase my dividend yielding equities using whatever limited spare cash I can squeeze and use the regular payout to fund my bargain hunting on good businesses going below their value? Unless there is a specular recovery of the share prices of all companies across the board, I am sure the dividend income will come in time to grab a few still neglected by the market.

Criteria for Yield Investing

Not all high yielding equities (predominantly Business Trusts such as REITS and Shipping Trust) are suitable for yield investing. There are a few criteria to meet which are derived from the objective of yield investing:

To provide sustainable, regular, and frequent dividend income.

Thus the criteria are:

1. Low volatility in business revenue, cash flow, payout policy and consequently payout, i.e. distribution per unit (DPU)
2. Simple and understandable business model
3. Sustainable business model
4. Relatively high yield (>20%)
   

FSLT and CIT easily met the 4 criteria with their clear and simple business model (buying assets and lease them on long term binding contracts) and sustainable DPUs. I was tempted to just invest in FSLT given it's current yield is in excess of 40% but I had to be rational and act with prudence. I need to diverify to ensure a sustainble and regular dividend income stream.

My Watchlist

Going forward, my current targets are Pacific Shipping Trust (PST) and Hyflux Water Trust (HWT). PST is simple, easy to understand and able to sustain its DPU. I had already talked about PST and will just discuss more on HWT.

HWT had long term concessions to run water treatment plants in China and revenue should be fairly stable so long as they are able to meet certain minimum treatment volume, though current economic climate could threaten the demand when companies pull out of the industrial zones the plants operate in. A greater concern arises on the yield itself. At last done price of 29 cents, the yield is about an annualised 19.24%. But the DPU for 2008 and 2009 included a 31.5% waiver from the sponsors who still hold on to some HWT units (i.e. giving up their dividend entitlements). Discounting the waiver, the actual yield would have been merely 13.2%. Further reducing its attractiveness, is the fact that the payout is only half yearly, compared to quarterly for REITs and shipping trust.

However, I see the long term prospects (and dividend) of HWT. If not due to the ongoing credit crunch, HWT could have raised more funds to take over more water treatment assets from Hyflux to boost its revenue stream (and dividend). Thus, if the price is right, I will consider getting some HWT to further strengthen my dividend income.

Conclusion

In a time where cash is king and conserving cash is key for short term survival, I must not lose sight of my long term objective and risk underinvesting for the future. In the midst of my resource planning, I came up with the concept of yield investing to fund my long term investing needs. Anyway, this should only work now as such ridiculously high yields will be a thing of the past when the economy recovers.