Saturday, June 27, 2020

In love with the shape of you (my economic recovery)

Lately, the stock market has been rather listless. Like dancing a slow waltz - two steps forward, one step back.

Image by Markus Winkler from Pixabay

Speculators hoping for some quick trade action must have been disappointed.

The wind of the bull rally a few weeks back has been taken out of the investors' sails.

The lack of direction feels as if we have entered the eerie eye of a storm. The unnerving lull before all hell breaks loose.

While most people are still worried about the virus and the economy, dissenting voices have started to pop up, arguing for the case that the worst is over.

Take Morgan Stanley. The investment firm proclaimed "greater confidence in a 'V-shaped recovery', citing positive economic data and policy action from health authorities, governments and central banks." [news]

Throwing his weight behind this idea is private equity juggernaut Blackstone Group CEO Stephen Schwarzman. He believes the economic reopening will spark a rapid rebound from the bottom set in the second quarter. [news]

Also joining the chorus are Stephen Innes, Chief Global Market Strategist at Axicorp [news], and former Goldman Sachs chief economist Jim O’Neill [news].

But clearly not everybody is as optimistic as these folks.

Certainly not the U.S. Federal Reserve ("Fed").

In its latest economic forecasts, the Fed projects a 6.5% contraction in U.S. GDP for 2020. [news] This is worse than the median 5.7% decline predicted by private economists, according to Bloomberg.

In other words, the Fed is warning investors not to bring out the champagne just yet.

Pundits expect Singapore to do no better. According to the latest poll by the Monetary Authority of Singapore, the local economy is forecasted to suffer a 5.8% contraction - huge contrast against the 0.6% growth projected in the March survey [news].

The Ministry of Trade and Industry had downgraded Singapore's 2020 GDP growth forecast to the range of -7% to -4%, from -4% to -1% earlier. [link] Should the 2Q20 QoQ GDP growth turns out negative, Singapore would have officially entered a technical recession.

Well, a terrible 2Q20 result is already priced in. It is water under the bridge. Experts are now looking ahead to the rest of the year for green shoots.

In its 3Q20 Quarterly Global Outlook, UOB sees "higher odds" of a V-shaped global recovery. [link] In fact, they see a "lower base case of a 45% chance of a U-shaped recovery, followed by a larger 30% chance of a V-shaped recovery and a similar 25% chance of a weak L-shaped recovery."

(I'm amazed how some economists can put a probability number to a guessing game.)

And the debate rages on.

On one end, we have the bulls who see the sunshine after the rain, and are willing to bet copious amounts of money in the stock market. On the other, we have the naysayers who think the collateral damage is done from the lockdown, and it will be quite a while before the economy gets its mojo back.

Who is right?

Are we going to have a V-shaped recovery? Or will it be a U-, W-, L- or geometrically complex shape of economic rebound?

The better question is: Who cares?

Unless you're a policy maker, or a central bank governor with a magic wand, chances are what you do will have very limited impact on how the economy heals. (You can buy that long-desired Rolex, or dine at your favourite Michelin star restaurant to keep the velocity of money going, but that's about it.)

My take is: don't bother with what the talking heads are spouting on financial media. Their job is to make educated guesses on the overall state of the economy, not on your personal portfolio.

Instead, focus on the one thing you can do, that will have a more lasting impact:

Select the stocks to invest in, WISELY.

Be sure the company which you agreed to be a co-owner of, has a strong balance sheet to survive any crisis, and a good record of earning profit and free cash flow year after year.

Market leadership, high barriers of entry, or a sizeable advantage over competitors are a definite plus.

And not forgetting an honest and capable management team at the helm, who do what they said, and say what they did.

In short, invest in the sort of businesses that will last through your children's generation.

As Warren Buffett quipped,

"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

When your portfolio is made up of these stalwarts, I can guarantee you will have a good night's sleep, even as the economy limps forward.

You can then sing happily to the addictive tune of Ed Sheeran's song, regardless of the shape the economic recovery takes.

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Sunday, June 21, 2020

A second look at Sembcorp Industries revenue portfolio

Sembcorp Industries ("SCI") had decided to part ways with its shipbuilding subsidiary, Sembcorp Marine. You can find the official announcement [here].

I used to be a SCI shareholder. I was attracted to the relatively defensive and geographically diversified revenue portfolio.

However, I sold all of my SCI shares in April 2019 after the Board opted to cut the dividend. Back then, the conglomerate was still making a reasonable 17 cents EPS, so I was disappointed with the Board's decision to distribute only 4 cents of annual dividend.

On hindsight, I was lucky to have gotten out at that time. SCI stock price had sunk 25 percent since then.

SCI price since April 2019. Data source: Yahoo! Finance

With the loss-making SCM going out of the picture, I received inquiries coincidentally from both my friend and my spouse on whether SCI is worth investing now.

I hadn't been keeping track of SCI developments, so I decided to take a second look. What I wanted to know is whether SCI's revenue portfolio - excluding SCM's contribution - is still as resilient and positioned for growth.

SCI's businesses can be broadly classified into three categories:

(a) Energy generation and waste management ("Energy");
(b) Shipbuilding and repair ("Marine"); and
(c) Land and infrastructure development ("Urban").

Of the three categories, the main revenue drivers are Energy (64 percent in FY2019) and Marine (30 percent). Urban forms a tiny 0.1 percent of the turnover and the remaining is classified as "Others" (I presume these are revenue from assets held for sale).

(a) Energy

The Energy division is involved in electricity generation from thermal power (both coal and gas-fired stations), import and supply of natural gas in Singapore, industrial wastewater treatment, renewables and retail power sales. SCI's main power assets are distributed across Singapore, China, India, the United Kingdom and the rest of Southeast Asia.

SCI's power station in Myingyan, Myanmar. Photo credit: SCI

With the recent focus on climate action, SCI has repositioned itself as a leading producer of green energy. It owns wind farms in both China and India, solar farms in India and Singapore and a battery storage system in the UK. Renewable energy now forms 22 percent of the total generation capacity. (For context, renewable energy was 14 percent of SCI's total generation capacity five years ago.)

SCI is also involved in industrial wastewater treatment and water reclamation, with facilities situated on Jurong Island, Singapore and in Zhangjiagang, China.

Lastly, SCI operates waste collection service in Singapore via its subsidiary SembWaste (you might have seen a SCI dump truck in your neighbourhood). In February 2020, SembWaste received approval by the Competition and Consumer Commission of Singapore to go ahead with its acquisition of Veolia ES Singapore, another local waste collection company [announcement].

A Veolia dump truck. Photo credit: Veolia

Graph 1 below charts the turnover and operating profit margin of SCI's Energy division over the past five years.

Graph 1. Turnover and OPM of SCI's Energy division. Data source: SCI FY2019 Annual Report

Revenue contribution from Energy has increased significantly over the years. However, the operating profit margin has declined to between 11 and 12 percent. While FY2019 EBITDA was up 17% year-on-year ("y/y") to S$1,309m, net profit dropped 38% y/y to S$195m.

Last year, SCI added new power generation capacity in Sirajganj, Bangladesh and Myingyan, Myammar. These assets should contribute to the turnover in the latest fiscal year.

While the company earned a net asset divestment gain of S$86m in FY2019, it incurred a whopping S$245m in impairment losses. The bulk of it (S$181m) was due to the markdown on SCI's United Kingdom Power Reserve (UKPR) assets. A confluence of reduced consumer demand (due to milder winters) and higher supply (from a delay in retirement of coal-fired power stations) resulted in tighter competition and lower margins, making the investment less valuable than projected.

SCI's United Kingdom Power Reserve (UKPR) system. Photo credit: SCI

Additionally, SCI booked an impairment loss of S$64m on its Chilean water asset, currently on sale to Spanish engineering group SACYR SA. It also recorded a S$23m charge in Jiangsu, China, where the company deemed its current water assets will not be able to meet China's more stringent effluent discharge standards.

While SCI did not provide a breakdown of turnover and profit by country, it explained the revenue decline was attributed to lower gas sales and planned maintenance shutdown of power assets in Singapore. One thermal power unit was also shut down in India in 1Q 2019 due to a stator fault, and there was the absence of contribution from South Africa's municipal water operations post divestment.

Notable local events include SCI joining the foray into Singapore's Open Electricity Market under the Sembcorp Power brand and the acquisition of Veolia ES Singapore. SCI also recently signed an agreement with Singapore's PUB to build Singapore’s largest floating solar farm on the Tengeh Reservoir [announcement].

My observations:

With the demerger of SCM, the Energy division will become the main pillar of SCI's revenue and income. FY2019 EPS from Energy was 10.9 Singapore cents (down 38% y/y). ROA was 1.51% and SCI quoted a ROE of 5.3% (down 36% y/y).

SCI operates in the heavily regulated space of utilities and waste management. These industries require significant capital expenditures upfront and the actual return is only known a few years later. Segmental liabilities form 75 percent of assets. While turnover is consistent and recurring, outsized profits are rare and unlikely.

Pockets of opportunities exist in emerging Asian economies for the company. While SCI is aware of the global trend towards green energy, it stated in its FY2019 Annual Report that "changing our portfolio mix will take time as there is a need to balance the transition with the goals of energy security, environmental sustainability, affordability and accessibility."

SCI's wind farm in India. Photo credit: SCI

SCI continues to build up capabilities in renewables and still believes UKPR holds positive long-term prospects as the UK undergoes decarbonisation. Hopefully, SCI has learnt a lesson or two from managing UKPR, and will be more realistic in making forecasts and bidding for future energy projects.

(b) Marine

The Marine division operates under the subsidiary Sembcorp Marine ("SCM"), and is concerned with specialized shipbuilding, repairs and upgrades, rigs, floaters and offshore platform construction. SCM operates five shipyards in Singapore and has similar facilities located in Indonesia, the UK and Brazil.

Sembcorp Marine Tuas Boulevard Yard. Photo credit: SCM

Back in its heyday (when crude oil was trading above US$100 per barrel), the Marine division was a significant revenue generator for SCI. However, as the oil price crashed from a market supply glut, the Marine division turned into a severe drag on the Group, bleeding cash in recent years.

Graph 2 below charts the turnover and operating profit margin of the Marine division over the past five years.

Graph 2. Turnover and OPM of SCI's Marine division. Data source: SCI FY2019 Annual Report

The Marine division had managed to eke out a profit in only two of the past five years. With the upcoming demerger, the Marine division will become a separate legal entity from SCI and its future profit and loss will no longer have any impact on SCI's books.

Thus, I will not concern myself with developments in this sector.

(c) Urban

The Urban division is involved in master planning and transforming raw land into urban infrastructure. SCI has current projects in Vietnam, China and Indonesia. In FY2019, SCI had a net orderbook of 423 hectares and a land bank of 2,600 hectares, evenly split between land zoned for industrial and commercial/residential development.

Artist's impression of SCI's International Water Hub in Nanjing, China. Photo credit: IWH

The Urban division had a bumper year in 2019, earning an operating profit of S$177m (up 88% y/y) and a net profit of S$117m (up 36% y/y). This comes from the recognition of profit in Riverside Grandeur development in Nanjing, China, and two residential projects BelHomes and Sun Casa in Vietnam.

SCI has long been involved with Vietnam’s Becamex IDC in the master planning of the Vietnam Singapore Industrial Park (VSIP). The company recently saw brisk sales from the market for its industrial land in VSIP Quang Ngai and VSIP Nghe An, and for new mass market homes in VSIP Binh Duong and VSIP Bac Ninh.

In China, SCI continues to work on the Sino-Singapore Nanjing Eco Hi-tech Island (SNEI). The completed Jiangdao Intelligent Cube business park within SNEI will cater to companies specialized in artificial intelligence research and development. Meanwhile at a separate site, the International Water Hub in Nanjing, China will focus on companies researching on handling water pollution and effluent discharge.

The Sino-Singapore Nanjing Hi-tech Island in China. Photo credit: SCI

In India, SCI and the State Government of Andhra Pradesh have mutually agreed to terminate the master development of Amaravati Capital City Start-up Area. (This wraps SCI's first Urban venture into India on a sad note.)

My observations:

The Urban division is turning out to be the spark in SCI's revenue growth, with a FY2019 EPS contribution of 6.5 Singapore cents (up 36% y/y) and quoted ROE of 11.4% (up 28% y/y). Despite the slowdown in China, SCI expects rental demand in their Wuxi-Singapore Industrial Park to remain resilient, as the tenants are in the higher value-added semiconductor sector. SCI continues to see strong market interest in its VSIP and SNEI projects.

Hopefully, this will cement SCI's expertise and reputation in master planning and industrial town development, thereby leading to more opportunities within Vietnam and China. The dissolution of the joint venure in India was a setback, but it should not have any material impact.


The future of SCI's revenue portfolio depends on opportunities in the utility sector within emerging Asian economies, as well as future industrial and business park development in Vietnam and China. While the COVID-19 situation is a dampener, SCI's Energy and Urban divisions should be able to maintain recurring revenue and income in the near future. The company took a bad hit from impairment charges in 2019. Absent of these one-off items, SCI's bottom line should improve.

SCI's power station in Sirajganj, Bangladesh. Photo credit: World Bank

On the bright side, SCI's Board had reinstated the annual dividend from 4 to 5 Singapore cents. If SCI is able to maintain or even grow this DPS, it should reasonate well with investors.

In the demerger announcement, SCI elaborated on a pro forma basis, its FY2019 ROE will increase from 3.5% to 7.9%, and its ROA will increase 3.5% to 5.6%. Its debt load will fall from S$11.6b to S$8.7b as at 31 Dec 2019. OCBC Credit Research had highlighted that SCI's EBITDA-to-interest ratio should improve from 2.3 times to 3.2 times [news]. A healthier balance sheet is always a good thing. Broker analysts are generally positive on SCI's future post demerger, with some calling for a possible rerating of SCI [news].

If we are to compare SCI to its nearest competitor Keppel Corp, Keppel looks to be the more favourable of the two. This is because Keppel has its toes dipped in more diverse industries, ranging from telco (M1) and data centres (KDC Reit) to fund management. Keppel also has higher margins, ROE and dividend yield.

The silver lining for SCI though, is the headway it has made in Vietnam. The Asian Development Bank has forecasted for the country to achieve the highest GDP growth in 2020 (6.8 percent) among the countries in Southeast Asia [link]. It is also broadly agreed Vietnam has benefited from the ongoing U.S.-China trade war [news].

Artist's impression of the Vietnam Singapore Industrial Park. Photo credit: SCI

For now, I wouldn't hold SCI for the simple fact that I do not want odd lots of SCM after the distribution in-specie. The ROE of a pure utility operator isn't sexy either. But I do think one year down the road, SCI may be worth a review, once the growth path becomes clearer.

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Saturday, June 20, 2020

Ignorance is a killer in the stock markets

It has happened.

My investing buddy shared with me the tragic story of a Millennial who recently committed suicide after he thought he had lost more than seven hundred thousand dollars through options trading. You can read the article [here].

20-year-old Alexander E. Kearns was a University of Nebraska student home from college and staying at his parents' place. In the midst of the pandemic, he started to learn stock investing. He had opened an account with the popular brokerage firm Robinhood Markets.

Alexander proceeded on to trade stock options in the market. According to Forbes, Alexander fell into a despair late Thursday night after he looked at his Robinhood app and found he had a negative cash balance of US$730,165.72.

Image by Bill Brewster in Twitter

There was not much details on how the huge deficit came about, but it was suspected that Alexander was trading bull put spreads.

This option strategy means you sell put options at one strike price. You then buy a balanced number of put options at a lower strike price. This is to limit your losses, in the event the underlying stock price drops far below at option expiry. If the stock price remains above the upper strike level, you get to pocket the difference between the option premiums paid and received.

In other words, you're betting on the stock to rally higher in price, and your options expire worthless.

Payoff chart of a bull put spread versus underlying price.

The danger comes when the stock price is directionless and hovers in-between the two strikes. You will have to cough up money and take receipt of the underlying shares (due to the exercise of the put options sold at the upper strike price).

But then, you will NOT suffer an absolute loss, because the underlying shares received will still command SOME value in the market. (That is, provided the company is not a bankrupt entity like Hertz Global Holdings.)

In Alexander's case, the negative cash balance was probably due to the exercise of the higher strike put options, but before the underlying shares were settled into his account.

In his final note, Alexander insisted he never authorized margin trading and was shocked to find his small account could rack up such an apparent loss.

No doubt the crave for excitement during lockdown, rock-bottom commissions and slick interface on Robinhood might have attracted Millennials like Alexander to use the app for investing. (The app was known to pop green confetti whenever users make their first trade [advertisement]. In Reddit, you can find user screenshots of snowflakes falling, which means your account balance is going down.)

Image by MyThrowaway404 in Reddit

Throw in human greed and jealousy into the mix, and this toxic combination can produce youthful speculative fervour with little regard for caution.

So intense that the life of a promising young man was lost.

Much as this was a tragedy for Alexander's family, it would be a stretch to blame Robinhood solely for his death.

Robinhood didn't kill him. Ignorance did.

Ignorance of how option assignment works.

Ignorance of proper risk management.

Ignorance of the fact that the market is chock-full of survivorship bias. (You don't hear pep talk from the millions who lost their fortunes in the crash.)

Ignorance of the reality that most people only share envious stuff on social media. (Few will rant about their embarrassing trading blunders on Facebook.)

Unfortunately, Alexander may not be the last victim in this 'financial pandemic'. My buddy recounted how some of his friends, whom had never touched investing before, recently started asking him for stock recommendations.

And I am seeing the same in my own social circle too.

The appearance of a media mogul-turned-day trader who boasted to be better than Buffett at stock picking doesn't help things either [news].

I sense a stock mania in the making.

I just hope there won't be a similar grievous ending on our shores.

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Thursday, June 18, 2020

A layman explanation of the Wyckoff Effect

Recently, an investing buddy introduced me to the Wyckoff Effect. Chartists and technicians may have heard of Richard Wyckoff, but this name is unfamiliar to me.

Image by mohisinabbas from Steemit

Richard Demille Wyckoff (1873 - 1934) was a trader, educator and stock market authority in the early 1900s. He was an astute observer of market action, and had developed his own trading technique based on watching the stock price and volume. Wyckoff emphasized on identifying the accumulation and distribution of stock by "smart money" (i.e. financial institutions) and to ride the trend as it develops.

There are two principles espoused by Wyckoff:

The first principle states every market and security is unique and never behaves in the same way twice. Present price movement bears no resemblance to any pattern in the past;

The second principle states since every price movement is unique, present price action should be studied in context to the price action on the previous day, week, month or year.

To ride a price trend, it is important to understand the forces behind it. Wyckoff had three laws to explain this phenomenon. For novices with a basic knowledge of economics, they are relatively easy to comprehend.

The three laws are as follows:

1. The Law of Supply and Demand - When demand is more than supply, the price rises. When supply is more than demand, the price falls.

2. The Law of Effort versus Result - Any price change is the result of an effort expressed by the security's traded volume. When there is consistency or harmony (i.e. a price change on increasing volume), the price movement will continue; when there is divergence or disharmony (a price change but on decreasing volume), the price movement will experience a reversal in direction.

3. The Law of Cause and Effect - Any price trend is due to the combined effort (or cause) in the market. The bigger the cause, the bigger the effect.

Wyckoff's Price Cycle describes the price movement in four phases: (a) accumulation, (b) markup, (c) distribution and (d) markdown. Any price movement up is preceded by the effort of financial institutions accumulating (buying) the stock. While the accumulation is ongoing, the price may trade sideways. When the supply eventually dwindles relative to the demand, the price will enter a markup phase (uptrend). As the price moves higher, there will come a point when the smart money starts to take profit (distribution). While the distribution is ongoing, the price may trade sideways. When supply eventually outstrips the demand, the price will enter a markdown phase (downtrend).

Image by Every Penny from Pinterest

In a nutshell, to benefit from trading the market, one should always swim with the big fish. Wyckoff provided an analogy of the "Composite Man", as follows:

"…all the fluctuations in the market and in all the various stocks should be studied as if they were the result of one man’s operations. Let us call him the Composite Man, who, in theory, sits behind the scenes and manipulates the stocks to your disadvantage if you do not understand the game as he plays it; and to your great profit if you do understand it."

Wyckoff has a witty example on how the average person ought to react:

"Figuratively speaking, therefore the small trader should imagine himself as a hitch-hiker in the market. For the ordinary hitch-hiker, someone else supplies the car, chauffeur, oil and gas. When he thinks the car is about to go in his direction, he jumps aboard and rides as far as he thinks the car will go."
"When he notices the machine has been stopped by a red light, or is about to turn a corner and go in some other direction, or that the car is running out of gas, or the brakes failing to work properly, he steps off and figures he has secured about as long a ride as he may expect."
"All he has supplied in this transaction is a modest commission and whatever brains were necessary to observe and recognize the opportunity when to get on and off."

There are plenty of websites that provide examples of Wyckoff's Price Cycle in action, and how to trade profitably from it. You can Google for them if you are keen.

To me, Richard Wyckoff's trading strategy makes sense. However, my purpose for investing is to accumulate positions in healthy companies that can provide sustainable dividend income through the years. So I am not really motivated to churn my holdings as they fluctuate between accumulation and distribution. (There is no telling when I can buy them back at the same cost the moment I sold my holdings.)

That said, I do believe studying the stock price movement can help an investor, albeit indirectly. If a downtrend is developing, we can ask ourselves whether to buy at the current price, or wait a bit to acquire the stock at a lower entry level.

While we can never predict accurately the bottom on the right side of the chart, the possibility of saving a few cents can provide a little less angst and a little more return when compounded over the long run.

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Sunday, June 14, 2020

Markets take the stairs up and the elevator down

I have a colleague, who is my soundboard on investing. We had an interesting Whatsapp conversation on Friday about the strange dichotomy between the stock market's impressive rally and the economy in the dumps right now.

One observation was the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX for short, started to spike again to a level of 40, after retreating steadily from a high of 66 during the market crash in March.

The CBOE Volatility Index, Source: Yahoo! Finance

The VIX is derived from prices transacted for the S&P 500 Index options, and is used as a proxy of investors' fear and uncertainty in the market. The higher the index, the greater the implied uncertainty.

Indeed, if you flip through financial news websites, there is no lack of articles quoting professional money managers on their hesitation of investing in the current market.

And we are talking about people who make buy and sell decisions in the quantum of billions of dollars for a living.

So if the pros aren't the ones chasing the momentum, there can only be one logical conclusion - this present rally is being driven by retail investors, notably newcomers whom had never thought of plonking money down on a stock before.

In the past, it was almost a hassle to go long on a stock. You would have to dial up your dealer, hoping he is around, check the current bid and ask quotes, and tell him (I presume it was mostly guys then) to buy 1,000 shares of Keppel for you.

Then came the Teletext, which was an improvement because you could stare at the television screen all day long to get the prices.

ST File Photo by The Straits Times

Nowadays, with the prevalence of the Internet and smartphones, buying and selling a stock is just a few clicks away. Mobile applications ("apps") such as Robinhood has made investing so simple and so cheap, it is almost game-like.

Login, select ticker, enter quantity and price, hit Buy and presto! It's game on.

But making investing easy has its dangers. This means the stock market is seeing an influx of new investors (or day traders) whom may have no idea of basic risk management, and no fear of failure. The 1997 Asian Financial Crisis and the 2008 Global Financial Crisis are a distant memory.

We are seeing proof of this naivete in the market. Bankrupt car rental company Hertz Global Holdings had just won judge's approval to sell as much as USD 1 billion dollars worth of shares to the market [news]. This comes after the stock climbed tenfold from a low of 56 US cents on May 26 to a high of US$5.53 last Monday.


If local water treatment firm Hyflux can perform the same magic trick, plenty of Hyflux PnP holders will be thrilled.

So it has become a game of musical chairs - Novice traders latch on a languished stock (with zero interest in the company turnaround) and wait for a bigger fool to take it off their hands at a higher price.

My own fear is this will become a vicious cycle - Millennials see their friend made a quick buck trading on Robinhood [news], decide to open an account, buy an airline stock from a hot tip, sell at a profit, boast on social media. Rinse, repeat.

And the stock market bubble blows bigger.

Till it pops.

An old investing proverb comes to mind, which may be worth remembering:

"Markets take the stairs up and the elevator down."

When every investor heads for the fire exit, there is bound to be a stampede. It is probable we will see big market swings in the weeks ahead, if the spike in VIX is any guide.

Hope you are buckled up for the ride.

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Thursday, June 11, 2020

Slice and dice the P/E Ratio like a pro

The humble Price-to-Earnings (P/E) Ratio is perhaps the most widely understood metric in the investment world. But you shouldn't use it as a proxy for a trading decision. This is because the number on its own, has very little actionable insight.

You see, the P/E Ratio is a lagging indicator. The numerator (Price) is the end product of a jostle between millions of buyers and sellers in the market. It is also the best gauge of all known and expected information out there. The denominator (Earnings) is the trailing 12 months' earnings per share of the company. And we know the disclaimer that historical result is not representative of future performance.

Usually, the broker analysts provide what is known as the forward P/E Ratio, which is to take the same stock price, and divide it by their own forecast of next 12 months' earnings per share of the company.

Now, there is a lot of uncertainty baked into the analyst's estimate, and it will be a matter of which analyst do you trust the most.

So what value does the P/E Ratio have?

You can use the P/E Ratio as a yardstick to find out what other investors (a.k.a. the market) think about the stock (and the company as a whole).

If other investors are paying 25 times per dollar of earnings for this company (P/E = 25), are you willing to be the bigger fool and pay 26 times per dollar of earnings for this company?

If the answer is yes, congratulations! You can go ahead and submit the buy order. Otherwise, you need to do some more digging.

To properly evaluate the P/E Ratio, you need to research it across two dimensions: (a) against time; and (b) against peers.

(a) Against time

It is not difficult to find websites providing historical P/E data of a company. You can pull up the numbers and check where the current P/E Ratio stands relative to the highest and lowest value over history.

For example, Table 1 below gives the P/E Ratio of CapitaLand as of 10 June 2020, and its highest and lowest values over the past ten years.

DateP/E Ratio
10 Jun 20207.22
30 Jan 2013 (Highest)18.57
06 Apr 2020 (Lowest)6.26
Table 1, Source: Morningstar

CapitaLand is currently priced somewhere near the bottom end of the range. At this moment, the market is not paying top dollar for the company's earnings, which is understandable given the COVID-19 situation.

But if the P/E Ratio is near its lifetime high, take it as an omen that the market is very hopeful - wildly optimistic perhaps - about the company. Too much euphoria flashes a warning sign, because you are going to find few buyers to push up the stock price further, even when you are confident the company will perform better down the road. When demand levels off and more sellers come onboard, there is only one direction for the price to go.

Some broker analysts go one step further and derive the mean value and standard deviation of the P/E Ratio, and tell you the stock is currently trading N standard deviations below the mean.

That's applying additional statistical analysis, but it doesn't necessarily mean the stock is a buy. There must be a reason for the metric to be so far below the mean. You may want to check out recent developments and see what could be causing this deviation.

Take note that P/E Ratio is meaningless if the company has recorded a loss. It is Price-to-Earnings Ratio after all.

(b) Against peers

Another way to use the data is to compare the P/E Ratio against other competitors in the same industry. For example, Table 2 below shows the current P/E Ratio of local real estate developers listed on the Singapore Exchange as of 10 June 2020:

SecurityP/E Ratio
City Developments15.34
Hiap Hoe13.83
Bukit Sembawang13.18
Frasers Property9.43
Ho Bee Land4.20
Table 2, Source: Morningstar

Ho Bee Land has the lowest P/E Ratio on the list while City Developments Limited ("CDL") has the highest. So the market is valuing Ho Bee Land cheaper than CDL at the moment.

If you think the market - and everyone else - is wrong, that Ho Bee Land should be worth more, then congratulations again, you have found yourself another trading opportunity...

Except I wouldn't be so quick to hit the 'Buy' button just yet.

Because there can be idiosyncratic biases that cause the market to price a company more or less favourably compared to other companies in the same sector. For example, Graph 1 below plots the difference in P/E Ratio between CapitaLand and CDL over the past five years. 

Graph 1, Source: Morningstar

As seen from the graph, the market has been pricing CapitaLand at a P/E discount relative to CDL since Q1 2017. What you want to know is whether the P/E discount (premium) is expanded (compressed) now compared to other times in history. There may be a company-specific reason for this phenomenon, and it is up to the inquisitive investor to find out.

Hopefully at this juncture, I have given you sufficient ideas on how to slice and dice the P/E Ratio effectively, so as to arrive at meaningful insights on your choice stocks.

Earnings are lumpy and do not change from day to day. Hence the stock price is the bigger influencer on the P/E Ratio.

Talking about price, I would like to bring up Benjamin Graham's renowned parable of "Mr. Market", as retold by Warren Buffett in his 1987 Berkshire Hathaway Letter to Shareholders [link]:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

In other words, despite all the advice about staying invested in the market, you don't have to buy NOW if the price is unfavourable (or the P/E Ratio is too high for your comfort.)

Market goes in cycles, and there will be a new price everyday. A window of opportunity will present itself if you wait patiently. Just remember to squeeze the trigger when the time comes.

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Monday, June 8, 2020

Hope is a miraculous drug

The Edge Singapore published a special feature written by CMC Markets on 5 June 2020, titled "When fundamentals fail". It aptly sums up the equity-economic divide that we are currently seeing in the markets.

You can read the article [here].

The world is still nursing from job losses and business collapses due to the artificially imposed economic lockdowns. Yet, if you have only a window to the world through stock market lenses, you can hardly be faulted to be cheery. It looks to be all sunshine after the torrent of rain in March.

Image by Mammiya from Pixabay

On Friday, the U.S. stock markets jumped, simply because the unemployment rate was much lower than expected (13.3 per cent versus the estimated 19 per cent). The disparity was so significant, it prompted news outlets to investigate why the economists had it so wrong. (You can check out one such article by The Washington Post [here].)

The truth is - as CMC Markets pointed out - amid the death and gloom caused by the coronavirus, people want to HOPE that the worst is over and good times are coming.

"Hope is an admirable human quality, but a poor basis for investment. It’s natural that human beings want a brighter future, regardless of reality. This may explain the rally. It was largely driven by hope for a cure, hope for a vaccine, and hope for a short and consequence-free lockdown. At this stage, none of these hopes is real." - CMC Markets

Even with the Floyd protests, China tightening its grip on Hong Kong, nearly 400,000 COVID-19 related deaths and the lack of a vaccine aren't enough to dent the jubilant mood on Wall Street.

Hope is indeed a miraculous drug.

Are investors prescient to cast a blind eye to the decidedly dismal Q2 results, and look forward to the second half of the year for glad tidings?

Frankly, no one has the answer.

But one thing is for sure - the chasm has to close. No bull can run forever, when there is blood on Main Street.

The negative base case is for stock markets to face the truth and drop back to recessionary levels. The economy re-opening is a boon, but the consumer behaviour is altered. People are wary about going out to crowded places. With the stringent restriction on number of customers in restaurants and stores, malls are unlikely to regain its liveliness anytime soon. While the government tries its best to create new jobs for the labour force, there is a limit to the number and the private sector is unable to pick up the slack. Work-From-Home arrangement shows employees can still be productive at home without being present in an office environment. Employers review their existing commercial rental arrangement, and decide to do with less. Shops depending on the midday office crowd for brisk business are impacted from a drop in patronage.

On the other end of the aisle is a positive base case for the economy to show resilience and a quick bounce back to pre-COVID-19 activity levels. Jobs are swiftly restored, thanks to the huge stimulus provided by governments in cohesion. The consumer is happy to go out and spurge, having been cooped up in the house for so long. News of a vaccine ready by the end of the year give people hope that we are going to survive this crisis and hence the optimism in the markets is justified. Stock markets rally to new lifetime highs. Global travel resumes, and visitors start to flock back to our shores. The tour guide and the cab driver are equally delighted to get back to form again.

Granted, the real situation will be somewhere in-between, with mixed blessings.

Only time will tell.

For investors who felt you might have missed the boat, do not fret. The hard facts are that it is NOT going to be all rosy, as if the world never encountered this coronavirus. The stock market will have to re-adjust somehow, to reconcile with the real economic picture.

Until then, bide your time and keep your powder dry and ready.

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Wednesday, June 3, 2020

Cracking the analyst's crystal ball

I swear I don't have a beef with broker analysts and their crystal ball, but I am amused sometimes from the reasons an analyst give to tweak their forecast numbers.

Image by Bruno /Germany from Pixabay

For example, an analyst's Target Price (TP) was adjusted up because of lower interest rate used in the discounted cash flow (DCF) valuation.

Technically, if you know DCF, that's not wrong. A lower discount rate means a higher net present value of future earnings.

Sadly, ceteris paribus (all other things being equal) exists only in an ideal world. In the real world, things don't correlate in a beautiful way. Most people suffer from a present focus bias. Try telling the provision shop owner he's richer now because SIBOR has gone lower. He'll think you're nuts, because he certainly feel no change. So why would a stock buyer be inclined to pay more for the same security?

Truth be told, a broker analyst is an extremely challenging job. Any form of forecasting is more of an art than a science. But even the weathermen have an easier time. They don't get slammed when it doesn't rain the next day as expected.

For a broker analyst, your head is on the chopping board when you stick your neck out for an imaginary number. When the customers want a price to buy the shares, it is tough to say, "I don't know", especially when your next paycheck depends on it.

That is why you don't see many broker analysts providing numbers too far away from the consensus. When you go for an extremely high or low forecast, you're either placed on a pedestal when it turns out right, or burnt at the stake when you get it dead wrong.

Another interesting reason given for raising TP is the rollover of fiscal year. When FY20 EPS estimate is 20 cents and FY21 is 22 cents, the Target Price automatically jumps higher as we cross over to the new year.

It's like growing a foot taller overnight as you celebrate your birthday.

Another example: the TP was raised due to the application of a higher P/E multiple.

I doubt any investor worth his salt will wake up, decide it's a bull market today, and pay more for the same dollar of earnings yesterday.

I sense the broker analysts rolling their eyes at me. Okay, in all fairness, I have absolutely no idea how to price a stock accurately. I mean, I know the valuation techniques, but there are so many factors to consider. It is mind-boggling, and my head hurt the last time I tried to work out the target price on MS Excel.

As retail investors, we probably shouldn't worry too much about the exact price to buy a stock. Because if a company is as good (fundamentally) as it gets, by virtue of profits and retained earnings, the market will eventually award the company a higher valuation. And hence a higher share price.

Of course, I say this with a caveat - The above doesn't apply during any bubble period. If you buy a stock at sky high valuation, be prepared to wait an awfully long time to get back to cost. (Or never.)

So my dear broker analysts, I feel your pain. It is hard to draw a bullseye around an invisible target.

And thank you for keeping me entertained as I read your reports throughout the circuit breaker period.

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