I upped my stakes in Surface Mount Technology on 27th May 2008

History

I had gone in and out of Surface Mount Technology (SMT) in the past few years while I'm still new to investing. Then, I'm pretty pleased with getting things below book value and even better when their ROE was high. That was when I got Surface Mount Technology.

25th September 2006
Bought SMT at 45 cents. I've thought I found a good business at a bargain, 15% below NAV and ROE > 15%. I learnt later that this was not sustainable.

29th June 2007
Sold SMT at 46.5 cents. While fundamentals are still deteriorating, I managed to sell them all during a period of exceptional market euphoria.

New Insight

After reading several books, especially Financial Statement Analysis and Security Valuation - Stephen Penman I am able to really understand why some companies trade for a premium above their book value (good businesses) and why others trade below (cigar butts). It all boils down to ROE, the quality of the ROE and its sustainability. Good ROE (I won't use the word 'high' here because ROE can be boosted with leverage or other tricks) means company is adding value for shareholders, resulting in having an intrinsic value above book. Bad ROE means management is destroying value, hence an intrinsic value below book.

Value investing just means buying a stock below intrinsic value. This was why Charlie Munger taught Warren Buffet: "It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price". This is in contrast to the pure Benjamin Graham style of buying purely below book value.

My Insurance

While acquiring a wonderful business at fair price is obviously better than getting a cigar butt, the problem is how to identify that business. i.e. how sure am I that the business I've identified as good (after going through years of financial statements, annual reports, product & services analysis, business analysis etc) is sustainable?

Lucrative business ultimately attracts competition and drive returns to cost of capital by the theory of regression to the mean. The only guard against the latter is competitive advantage and sad to say, I've not acquired the business sense to identify one.

Hence, my only solution (until I picked up the business sense to identify one good business with sustainable competitive advantage) is diversification. I had 'good' business as well as 'cigar butts' in my portfolio. As far as cost of investment is concerned, each business in my portfolio take up similar chunks. This way, I minimize the cost of my mistakes. The flip side is I limit my gains too. Anyway, my investment objective is to insure against retrenchment, not to get rich (not that I don't want to get rich, but its not my foremost priority, I'm more paranoid about retrenchment and lost of income).

Bought again, with a clearer picture

If I bought SMT back in 2006 as a green horn to investing, now I won't have excuses any more. I gone into the mud with my eyes wide open, fully aware of the risk involved. Anyway, on 27th December 2007, I got in again at 26 cents a share, which is about 52% discount to the NAV then.

Grabbing the falling knife

Today, I upped my stakes again, at 13.5 cents a share. According to the unaudited Full Year results, it's about 75.3% discount to NAV. Looking at the balance sheet, (assuming the balance sheet numbers represent true and fair values):

Current Assets

1. Trade receivables per share----------------------26.0 cents
2. Inventories per share-----------------------------24.3 cents
3. Cash per share------------------------------------9.1 cents

Total current assets------------------------------------59.4 cents

Non-current Assets

1. Plant, property and equipment------------------80.2 cents
   

Liabilities

1. Total Debt-----------------------------------------88.1 cents
   

Assuming plant, property and equipment is fairly valued, together with a little of current assets, there is more than enough to cover all the liabilities. This means that at least 50 cents per share can be recovered if the company go into liquidation now.

If inventories are worthless in a fire sale, 50 cents less 24.3 cents equates to 25.7 cents. (nearly 2 times of 13.5 cents).

Risk

For a company to be sold at such a sorry price is not without reasons. The following might be enough to justify a discount (but not such obscene discount):

1. Profit margin squeeze (rising cost, pricing pressure from competition)
2. Profit to loss making
3. No recovery in sight (at least not in the next few quarters)
   

Conclusion

For companies like SMT, the management is obviously destroying value for shareholders. The resources could have been deployed elsewhere for much better returns.

The only way I'll be rewarded now is to wait patiently (but for how long???) for a coporate raider OR a complete turn around in the business. The good thing about cigar butts is the situation is normally pretty bad and are already condemned to the recycle bin by the market. Hence any improvement (from very bad to bad is also an improvement) will be rewarding for the shareholder who dare to catch the falling knife.

Finally, I let go of Surface Mount Technology on 29th June 2007

For reasons I do not know, Surface Mount Technology, SMT's share price have recovered to a level where I can let go and break even (including covering trading cost). I already identified SMT to be one fighting a somewhat losing battle in the ultra competitive EMS solution business. With escalating cost of business, pricing pressure and without a clear strategy or ability to compete, the profit erosion is inevitable.

Whether there is anticipated turn around in SMT or due to speculative forces at work resulted in the escalating share price. Despite this, I am not prepared to hold on to SMT. From what I could see, there is no change in business fundamentals to justify the market revaluation. I am already happy to get out without losing a cent on SMT (excluding time value of money holding SMT for 9 months). I exited at 46.5 cents and it closed that day at 49.5 cents.

2nd Cigar Butt, Surface Mount Technology's 2Q Results in November 2006

I bought Surface Mount Technology at about 15% below NAV. Its ROE used to be above 15. 2Q earnings nearly tumbled 40%. What went wrong?

Apparently, Surface Mount Technology, operating in fiercely competitive EMS market, was facing a profit margin squeeze too (a keen to United Food) . On one hand, its facing escalating prices and shortage of raw production material. The shortage arose because suppliers do not hold much materials in stock due to highly volatile prices.

On the other hand, Surface Mount Technology was facing pricing pressure to maintain market share. The end result was profit margin squeeze and hence tumbling profits.

Without a clear and viable strategy to compete with its rivals, it would be difficult for Surface Mount Technology to reverse the trend of dwindling profits.

Share price of Surface Mount Technology subsequently tumbled to slightly over 30 cents, or nearly 50% NAV, earning it a seat in the cigar butt category too.

This brings my cigar butt count in my portfolio to 2:

1. Surface Mount Technology
2. United Food Holdings

Reinvest profit from Golden Agri-Resouces in Full Apex and Surface Mount Tech in September 2006

On one hand, I continue to read up financial textbooks and other investment books, as if I'm preparing for CFA. On the other hand, with fresh funds after disposing Golden Agri-Resources, I started to look for new opportunities. I just couldn't let my cash idle away in the bank.

By September 2006, I started to accept that good business (displaying high ROE, e.g >15 ) might justify share price above NAV while under performing ones (displaying low ROE, e.g <10)>15), it is also trading below NAV by about 15%. Next I bought Full Apex at 29.5 cents. Full Apex manufactured PET bottles and had prominent customers like Pepsi-Cola as its clients. But it was trading slightly above NAV for ROE greater than 15 too.

Originally, I was quite confident about Full Apex. Though it faced rising price of raw materials due to high crude oil prices, it decided to build its factory to produce plastic resin, an intermediate raw material for making PET bottles, to deflect some of the rise in raw material cost. I thought such vertical integration in business operation was good until a fellow value investor pointed out that not all companies benefit from vertical integration, else why would many out-source some operations. Anyway, I didn't hung on to Full Apex before selling it off because I was still not comfortable with above NAV counters. I subsequently sold off Full Apex at 31.5 cents in the same month when I thought the general market had appreciated too much and was due for another correction. I thought then that I could wait out for another under NAV gem.