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Tuesday, 27 May 2008

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.

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2 Comments:

Blogger musicwhiz said...

Hi Market Uncle,

I would like to comment on your purchase of more SMT at 13.5 cents.

A casual glance at SMT's financials shows deteriorating margins and a profit to net loss situation for FY 2008 ending March 31. Though distribution costs had dipped, admin expenses soared 34.8% which more than offset the meagre 7.1% increase in revenue (I am talking about 4Q 2008). This had caused a loss of HK$21.8 million which is very substantial if you consider the fact that in prior period, profit after tax was HK$14.2 million.

In addition, the Balance Sheet also shows that quick ratio is below 1, meaning most of the company's assets are tied up in Inventory. You used a model whereby you computed the liquidation value of each class of assets to justify that NAV is at least 50 cents per share. However, inventory in a fire sale (as you say) may not be worth much and importantly, fixed assets may not be able to be liquidated at book value (historical cost) due to depreciation. Hence, market value of fixed assets may be substantially lower than book value and you should use NRV to value fixed assets and not historical costs. The practical problems involved in selling fixed assets quickly to generate cash is also another issue. Therefore, I do not think that the 50 cents per share NAV is a reasonable measure of the company's worth at this point in time.

Another factor I will consider is that since Management is destroying shareholder's value (not creating it), the book value per share may consequently also fall and this may be the reason why the share is trading at a significant discount to book NAV.

Looking at their presentation slides, their net margin (when they were profitable) is historically very low (highest was 5.9% in FY 2004) which represents a very risky business model (as in this case, a small escalation in costs can wipe out residual traces of profit). Cash burn is also pretty severe as both FY 2007 and FY 2008 recorded a drop in cash balances with no corresponding improvements in profit, implying that purchased assets (most of their cash outflows relate to investing activities) are not being effectively utilized to generate profits/cash.

In summary, the company is operating under very difficult business conditions and the industry itself is commoditized with no apparent competitive advantage which the company can demonstrate.

Hence, I am puzzled by your intention to purchase more of this company to average down your cost of purchase.

Regards,
Musicwhiz

P.S. - Pardon me for being rather frank and direct, these are just my observations as a layman to this industry and by reading the financials and presentation.

30 May 2008 at 02:52  
Blogger Market Uncle said...

Hi Musicwhiz,

Thanks for giving your frank comments. I do appreciate them alot.

I take this discussion in 3 parts:
i) discount to NAV
ii) cash burn
iii) resilience of a going concern

i) discount to NAV

You brought up a point that I didn't realise until now. All along, I thought fixed asset are "fairly" valued, factoring depreciation. However, there's always a huge decrepancy between the number on the balance sheet and the actual net realizable value during a normal market sale (let alone a fire sale).

I've looked it up a little and the following put it well:

...
Estimating an asset’s useful life solves half of the depreciation question. What about the rate of depreciation? Will the physical deterioration of equipment occur evenly over its useful life or will the decline be more rapid at the beginning or end of an asset’s useful life? Should depreciation be based on the decline in an asset’s economic value instead of its physical deterioration? The two forms of decline do not necessarily occur simultaneously. For example, the market value of computers declines very rapidly compared to their physical deterioration.
...


In short, since the fixed assets would be worth much less then what's reflected on the balance sheet, the actual discount to NAV would not be as big as my initial estimate. The actual recoverable value per share if the company are to go into liquidation should then be substantially lower than the 50 odd cents I've estimated.

ii) Cash burn

While a net loss of 21.8M in Q4, 2008 vs a net gain of 14.2M in Q4, 2007 is a huge plunge. A closer look at the cash flow statement can tell a slightly different picture.

Cash generated from operations in Q4 2008 is 9.565M vs Q4 2007's 39.6. But Q4 2008 is dragged down by an increased inventory of 33.6M vs a decreased inventory of 25.5M last year. If the management can still be believed, "The increases in inventories and trade payables are to prepare raw materials for production to fulfill customers’ order
requirements."
. The cash flow from operations is actually still decent. The seemingly huge net loss this quarter is an accounting fact, not yet a operational fact. Cash is not burnt yet, unless the built up in inventories is a result of canceled orders from customers.

iii) resilience of a going concern

From negligible profit margin (you are right that its about 5%) to loss making, the company just keep performing worse than before.

However, if management is determined to pressed on, there might be light in the end of the tunnel. As least they are still building/fitting out factories; banks are still granting them loans. I take these signals to signify that the management believe the business can persist and the banks believe the business can continue to generate the capacity to repay the loans.

As with all cigar butts, the management have done all the can to destroy shareholder value. Anything right out of the many wrongs will result in an improvement.

30 May 2008 at 23:26  

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