What a Start to the Stock Market in 2016!

Portfolio Results for 2015

I think readers of this blog would probably have guessed that I did OK in 2015. AP Oil

gained >46%, Avi-Tech gained >38% but Sembcorp Industries crashed a hefty -34% (all returns before dividends) since my write-up in this blog. What a crazy ride in 2015: On a portfolio basis and taking into account dividends received, my Singapore portfolio went as high as +18.7% (August) but ended off the year with a +12.8% gain while my Hong Kong portfolio went from +48.5% (May) and ended 2015 with +25.7%.

Will 2016 be a good year for stock markets?

Despite a 15% decline in 2015, our STI index continues to register losses in the first few days of 2016. From its peak of about 3550, the index had sunk about 23%. Will 2016 be a down year again? Honestly, your guess is as good as mine.

Opportunities Abound

For me, rather than trying to predict at the macro level, I feel it is more fruitful to focus on valuations of individual companies. Despite the uncertainty surrounding the market, make no mistake about it: there are more opportunities to take advantage of than it was just a few months back. Uncertainty is the friend of the buyer of long term values. Always be extra cautious in your dealings with the Mr Market but never be afraid of taking strategic advantage over him.

What I am going to do in 2016?

The wider the fluctuations of the market, and the longer they persist in one direction, the more difficult it is to preserve the investment viewpoint in dealing with common stocks. I think it is of utmost importance for an investor to have a logical process for investment and have the mental & emotional fortitude to stick to it despite daily market gyrations & noises. Different investors have different philosophies and the following is what I found quite useful (at least for me) thus far:

1. Try to get a general sense how the business operate
2. Ask yourself honestly if you can reasonably see the company still in existence and operating well >10 years later
3. Limit your risk - ensure the company is in sound financial condition
4. Limit your risk yet again - make sure the price you pay is significantly below your estimate of the business' value
5. Diversify your risk adequately
6. Have patience and conviction for value to be realized - the market for short term returns is very competitive but the market for longer term returns is much less competitive

These pointers are quite similar to my post on Our Investment Philosophy and I intend to adhere to it in 2016 and beyond.

Final Note

I’ve been slowly accumulating a few SG and HK stocks in the past few months and one of them appears to be a rare find – having reasonable defensive characteristics with potential for growth and selling at extremely attractive prices. I intend to concentrate more on that particular stock, probably towards 15-20% of my portfolio. If I have the time, I’ll probably discuss more about them.

A few friendly readers actually emailed and asked if I’ve stopped writing. I very much like to continue but will likely do so with shorter posts and at a very leisurely pace. Meanwhile, I’ll be more than happy to discuss investment related questions via the comments section of this blog or email at secretinvestors@gmail.com. Happy stockpicking!

Q&A: Insights Gained from Interesting Comments

I mentioned previously in the post on Our Stock Investment Philosophy that one of the reasons for writing in this blog is to subject our investment thoughts to scrutiny and feedback so as to gain new insights in our investment journey. In the past 2 months, there are multiple comments from fellow bloggers and readers about my writings that I feel adds so much value to this blog. I couldn't ask for more. I'll like to take this opportunity to thank readers for their insightful comments and also republish some of these for the benefit of those who had have missed these comments despite reading the article.

I've tried my best to be selective and also to summarize these questions and answers so that readers can get the gist of it. Also, to save time, I've organized in such a way that you can go to the relevant heading and/or question that interests you. Of course, there are more comments which are very insightful and definitely worth a look if you have time. If you want more details, you can click on the headings to go to the relevant article (the comments section is below these articles, scroll down all the way if you want to read only those).

Sembcorp Industries - Is It Worth the Buy Now?

The one thing analysts and all investors (and myself) have been saying is the low PER their utilities segment is currently valued in. We think it's cheap if we compare it against fellow peers. But the question is, it has been for many years they are trading under PER of 10x, so I'm not quite sure what would propel the shares to be trading at 15x. We may be too optimistic in that sense. We may be wrong of course but the market has proven us wrong again and again. Will we see a day where it is trading at PER of 15x? Maybe yes one day, and we can only hope. 

Reply: I suspect that many investors or potential ones are still deeply fixated about Sembcorp’s Marine business and has not been aware of the success and growth of the utilities business, thereby undervaluing it. Like you, I’m also not sure what would propel the shares of the Utilities segment to 15x. But assuming we are not comparing with its peer businesses or the market's valuation, and only basing strictly on a discounted cash flow perspective, I think this valuation is fair considering the economic characteristics of Utilities segment (leading position, stability and predictability of cash flows etc). Basically on a zero-growth basis we are putting a discount rate of 6.7% for a respectable business.

Also, my hunch is that my valuation for the Marine segment is probably a tad too low (Earnings power of S285M vs TTM earnings of S$345M plus PER of 12-13X) and I have considered the Urban Development business to be worth zero which is definitely not true.

Lastly, some final considerations which I did not include in the post is that – the Marine segment is probably the one providing the cash for Utilities expansion traditionally. If Marine is unable to do well under current circumstances, the Utilities might be affected. Sembcorp claims that the small Urban Development business may be a springboard for further involvement in opportunities for Utilities side but so far I haven’t really seen any synergies in this aspect (anyone, please correct me if I’m wrong). I guess these business relations wasn’t completely factored into my analysis. The valuation might be higher or lower because of these but I must really thank the margin of safety for providing some comfort here.

As an investor of SCI too, I feel pretty confident. Yet, looking at the price curve, I noted that in Oct 2011, there is a dip of prices below 3.5? And that was already way beyond post crisis low period below 2.5. I had not followed SCI then and was curious why did that happen? Just pondering will a repeat happen?

Reply: Great questions posed there regarding the price chart. I think your guess is as good as mine whether a repeat of price below S$3.50 or even S$2.50 will happen. Personally, I feel there’s always a chance something like that will happen again though.

However, looking at this situation on a value standpoint may be a source of vindication. The ~S$3.40 price occurred in 2011Q4. In terms of available information then and for simplicity, we can use 2010’s financial data for reference. With earnings of S$793M (you may want to refer to the table in my post), the PER turns out to be about 7.7x which is also very attractive. Perhaps that is why over such a short period of time 3-6 months, the stock price recovered.

Alternatively, if you follow my post and using the same technique, (Here, I assume that my view of the fundamentals/stability for both Marine & Utilities is the same at that point in time as it is now (this is quite likely) & I also used latest results for Utilities but 7-years average for Marine instead of 10 years), the valuation becomes S$6650M or about $3.70/share. I ignored the other segments in both cases. It turns out that this is decidedly less attractive at that point of time compared to now on a price to value basis (Value VS Price – 2011 is S$3.70 VS S$3.40 & 2014 is S$5.15 VS S$4.15). Thus we can say that even though the price is lower at ~$3.40 in 2011, it is not necessarily more attractive when it is priced at S$4.15 in 2014. Of course there may be bias (hindsight) etc but I’ve tried to minimize them using the same method when looking at the company for both periods.

I guess the point here is that due to business developments over the years, we have better clarity in forming a rough intrinsic value estimate of the business itself which in 2014, we estimate it to be close to S$5.15 wherein we ‘wrongly’ estimate it to be at S$3.70 based on the available data in 2011. Without any doubts, we may yet again be proved wrong as the future unfolds. That's why we can't depend only on this counter in our entire portfolio.

Not satisfied with the dividend yield.

Reply: The dividend yield for Sembcorp Industries is not the best among many of the blue chip stocks around. However, I suggest that dividend yield is part of the overall analysis. 

If after analysis, we like a stock like Sembcorp but we feel the yield is too low, I think there's 2 ways to handle this: 

1. If you feel that dividends will remain constant, wait for the price to drop further to get a higher dividend yield; or

2. Ensure the current price is low enough such that there's good upside for capital appreciation. Buy at this low enough price and hope that based on the fundamentals & potential growth of the company, the earnings will increase in the long-term and maybe future dividends will increase as a result.

For me, since the current dividend yield is already good enough for me and the company has been paying dividends yearly for >10 years now, I opt for the latter point 2 which is obviously the less wiser way.

Avi-Tech Electronics - Is Quick Profit Possible?

Seems this company has trouble finding ways to make money? It's longer term prospect doesn't sound exciting. Be careful of considering liquidation value based on its current cash. Check how much it burns as well. Can disappear quickly due to operating expenses if it isn't generating profitable sales. That margin of safety may not exist.

Reply: Thanks so much for visiting my blog. I think you’ve raised a valid point here. The longer term prospect doesn’t sound exciting at all. However, I believe the beaten-down price coupled with the various corporate actions that act as some sort of catalyst have made the stock a potentially attractive investment.

With regards to liquidation value, I’ve used it as one of the indicators of the company’s value. Like I mentioned in this post, between 2011-2013, the bulk of negative earnings are attributed to the subsidiaries (they contributed –S$12.8M while core ops contributed +S$1.7M). These loss-making subsidiaries are the exact same ones that management will discontinue and this will help stem much of the losses. Core operations endured comparatively minor losses which was worst at -S$1.61M in 2013 (VS subsidiaries –S$7.6M in 2012). 1Q2015 shows core business operating profitably signalling a potential turnaround. 

With these, I believe the company is unlikely to burn as much cash as the past 3-4 years and correspondingly, the liquidation value can be used as a reasonable guide to its valuation at this point in time. Of course, the future is unpredictable and management can still burn cash in the future, especially through similar unsuccessful acquisitions. What I can say is that I did not place any positive prospects of the future in my valuation while the negative prospects are still guarded by some indication of margin of safety.

All in all, if I can find a few companies in this investment situation and at this price level for my even-type portfolio, I think the probability of profiting should be high overall. If you read my previous post on My SG Portfolio 2014 and Some recent picks,you will notice some companies in my event-type situations aren’t doing very well operationally and doesn’t seem to have bright prospects (one of them is facing a lawsuit too). I guess the point here for me is that because of these past losses, the price of Avi-Tech had been beaten down by investors/speculators to a point so low that they have essentially assumed these losses are very likely to continue far into the future.

How to Get Rich - The Beauty of Compounding to Investors & Companies

Have you tried using simulation which is the most important factor out of the three? Time, starting capital or return factor?

I think you’ve posed a very valid case here about finding out which is the most important factor. Honestly, I'm not very good at such simulations. But if you've noticed, I've used a factor of 1.5 for rate of return, r and starting capital, P in the case study (i.e $100K x 1.5 = $150K, 10% x 1.5 = 15%). For time period, t, if we use a starting capital of $100K and 30 years (20years x 1.5), the final amount would be about S$1.75M. From this single but likely inconclusive datapoint, it appears that time period and rate of return are the most important factors to consider.

Unfortunately the rate of return probably is one of the least predictable of the 3 factors since there's no way we can be sure we can achieve 10% or 15% return over the long haul. Because of this unpredictability, I thought it is not so useful to state which factor is the most important in the practical sense. However, very fortunately for us, the time period is quite within our control and easily ‘applied’ if and only if we are young enough to start. Then again, achieving a 2-3% return over the long haul is probably easier than say, compounding it for 50 years due to the limitations of being a human. A balanced effort in working on all factors should be the better way to handle the compound equation.

All the 3 factors are highly intertwined and complementary to one another. For example, compounding $100K at 15% for 18, 19 and 20 years will give $1.24M, $1.42M ($180K more from 18th year), $1.64M ($220K more from 19th year) respectively. A good compound rate is important but the effect will be more pronounced if the length of time is extended due to the exponential effect of the formula. Similar relation applies for the other factors.

In conclusion, due to the varying ease of application and unpredictable nature of some factors, it is quite hard to conclude decisively which factor will do most for us in our lifetime. Consequently, I believe the best way to reconcile this is to focus on all 3 factors based on my proposed method to tackle each factor in my post (under The Real Trick – Combining all 3 Inputs).

THE BEAUTY OF COMPOUNDING COMPANIES & ITS IMPLICATIONS

Good post again to show the different scenarios amongst the 4. It's interesting though that you actually used the book value as a measurement of growth. I thought book value growth is much harder to achieve than earnings growth as it covers a wider spectrum. It is like earnings is the subset of that.

Reply: I used book value in this case because it's easier for me to explain the compounding effect. Also, unlike earnings and cashflows, book value is less subject to fluctuations with time and thus more predictable for use. Besides these, book value is highly related to earnings - A consistently growing book value usually indicates healthy earnings over the period since whatever is left in net income after deducting dividends goes to the book. Lastly, we can also view book value as a rough gauge to the company's intrinsic value if it is to be a liquidated. This means that using book value is not wrong although it may not be the best choice in the end.

Other Articles:
My SG Portfolio 2014 (Top Realized Gains & Losses) and Some Recent Picks
AP Oil - A Neglected but Cheap Stock in Singapore
Our Stocks Investment Philosophy

My SG Porfolio 2014 (Top Realized Gains & Losses) and Some Recent Picks

My portfolio experienced quite a few changes in 2014 and I thought its good to highlight a few for my own tracking purposes. I consider this year a lucky year for me as I've sold my 2 main losers before it went down even further. I'm glad to realize a few winners too although most of them went even higher after my sales. Also, my event-type portfolio did not register any losses for 2014. Currently I have 15 Singapore companies in my portfolio and throughout the year it fluctuated between 14 to 18 stocks. Percent wise, my largest total unrealized loss currently in my SG portfolio is -4.4% while the largest total unrealized gain is about +61.3%, both inclusive of dividends.

I classify my portfolio to 2 main types. The first is the normal ones where we just make the purchase based on its quantitiative & qualitative strength and hold on to them until value is realized. The second type consists of event-driven stocks wherein their results depend a lot on certain external or internal corporate action(s) which I feel will close the price-value gap in a reasonably short period of time. Unlike in the USA, these situations are few and far between in Singapore. Consequently, I define them quite loosely and am pretty flexible with the type of event that occurred. For this group, I ensure that there is at least some degree of undervaluation before I make my purchases just to be safe.

Below is a list of my top realized winners (I define this by a more than 30% gain on an annualized basis) and my worst realized losers (Since annualized loss shows less meaning here, I define it by a total loss of more than 10%). Typically I'll buy up or sell down my shares on a scale over a period of time. To make things simple, my annualized returns are based on a maximum holding period which means the actual returns should be slightly higher.

Top Realized Winners

SMRT Corporation Ltd

Average Cost (Incl. Fees): S$1.02

Average Sold: S$1.49

Max Holding Period: 211 days

Returns (net of costs, include div) based on avg price: +47.6%

Annualized: +96.0%
Comment: Quite lucky here as a short while from my initial purchase, the price spiked up due to government's announcement about the new model. Nevertheless, the price at S$1.02 was clearly undervalued. The non-fare segment of the company was rather attractive too. Considering the nature and moat of the business, I probably run the risk that I've sold too low at S$1.49. Price now is S$1.58.

PNE Industries

Average Cost (Incl. Fees): S$0.1044

Average Sold: S$0.167

Max Holding Period: 480 days

Returns (net of costs, include div) based on avg price: +82.25%

Annualized: +57.8%
Comment: Price now at S$0.151.

UE E&C Ltd

Average Cost (Incl. Fees): S$0.737

Average Sold: S$1.20

Max Holding Period: 694 days

Returns (net of costs, include div) based on avg price: +77.4%

Annualized: +35.2%
Comment: Price now at S$1.26.

Koyo International

Average Cost (Incl. Fees): S$0.0528

Average Sold: 0.0864

Max Holding Period: 688 days

Returns (net of costs, include div) based on avg price: +66.4%

Annualized: +31.0%
Comment: Unfortunately the price thereafter went up as high as S$0.194. If I'm a bit more patient, it could have been a 250+% gain... Price now at S$0.154.

Worst Realized Losers

Vard Holdings  

Average Cost (Incl. Fees): S$1.097

Average Sold: S$0.958

Max Holding Period: 468 days

Returns (net of costs, include div) based on avg price: -12.7%

Annualized: -10.0%
Comment: This is probably my most foolish purchase in 2013. Fortunately, I sold months before the steep fall in oil prices. Counter is at S$0.595 now.

Fujian Zhenyun Plastics

Average Cost (Incl. Fees): S$0.168

Average Sold: S$0.155

Max Holding Period: 934 days

Returns (net of costs, include div) based on avg price: -1.8%

Annualized: -0.71%
Comment: Lucky here as I heard it is recently suspended due to some issues with its accounts. Price now at S$0.149.

Top Event-Type Winners

Fuji Offset Plates Manufacturing Ltd

Average Cost (Incl. Fees): S$0.35

Average Sold: S$0.45

Max Holding Period: 2 days

Returns (net of costs, include div) based on avg price: +27.9%

Annualized (Simple Average): >5000%

Captii Ltd

Average Cost (Incl. Fees): S$0.0351

Average Sold: S$0.041

Max Holding Period: 123 days

Returns (net of costs, include div) based on avg price: +17.5%

Annualized: +61.3%

From both the realized and unrealized results, I'm glad that my endeavor to ensure the risk of permanent capital loss is kept to the minimum has been working well. More details about my investment philosophy can be found in my post here. As always, I find that the timing of sales is always the hardest part of the entire investment process. Should we wait for the momentum to fizzle before selling even though it is already above my estimated value? But then again, how do we know that momentum has fizzled and what if the price falls below intrinsic value and never goes back up again? Because of this problem, I tend to start selling in phases when it is near my estimate of intrinsic value range. I guess the trick here is really to make purchases at a price so low that even if the sale is mediocre, the eventual results will still turn out good.

Some Recent Picks

I shall end off this post with 3 recent picks for my portfolio. For the normal portfolio, they are Sembcorp Industries and AP Oil International. You may want to check out my analysis for Sembcorp Industries here and AP Oil here. The event-type pick would be Avi-Tech Electronics Limited (company website) which I have accumulated at an average price including costs of S$0.699. Let's see how things goes from here. What about you guys? Care to share what are some of your picks? Have a fantastic 2015 ahead!

Related Articles:
Sembcorp Industries: Is It Worth The Buy Now?
AP Oil - A Neglected but Cheap Stock in Singapore
Avi-Tech Electronics - Is Quick Profit Possible?

Disclosure:
Long AP Oil, Sembcorp Industries & Avi-Tech.

SEMBCORP INDUSTRIES (U96.SI): Is It Worth The Buy Now?

The recent oil price rout has beaten down many stocks of oil-related companies and probably its good to have a look to see if valuations are compelling enough. Now, I usually like to buy clear-cut bargain type stocks and consequently most of my portfolio consists of small to mid cap businesses like AP Oil (see post here for full details). However, one of the rare blue chip companies that I monitor is Sembcorp Industries. Some metrics (based on 8 Dec '14) as follows: 

Price = S$4.15
Shares Outstanding = 1801.4 (million)
Market Cap = S$7,565 (million)
P/E (TTM) = 9.70
P/NTA (mrq)= 1.51
ROE (ttm) = 14.91%

SEMBCORP INDUSTRIES BUSINESS

I wouldn't go into details about the business but will probably highlight a few things so that the reader can get a general understanding about its operations. I encourage you to look at the Company's Website as it provides a comprehensive overview of its businesses here.

Sembcorp Industries is listed in the SGX and its business consists of 3 main segments:

Utilities

Developer, owner and operator of energy and water assets over 6 continents with an established presence in Asia and growing presence in emerging markets. The company has established a niche as a global leader for the provision of bundled energy, water and on-site logistics to customers in energy-intensive industrial sites, and as a developer, owner and operator of large-scale combined power and water plants.

Sembcorp Utilties Network

As shown in the picture, the Utilties segment already has a global footprint (including emerging markets) and the guidance was that there's still potential for expansion. This segment of the company is what probably attracts many investors now due to its natural moat, source of recurring income as well as potential growth.

Marine

Separately listed in the SGX, this segment is a leading global marine and offshore engineering group specializing in a full spectrum of integrated solutions in ship repair, ship building, ship conversion, rig building and offshore engineering and construction. This segment is likely causing the steep decline as it is highly related to the oil industry. 

Urban Development

Sembcorp owns, develops, markets and manages urban developments such as industrial parks, business, commercial and residential spaces in countries like China, Vietnam and Indonesia. The company's early involvement in the development of industrial, residential, business and commercial areas also provides potential opportunities for the provision of utilities and other solutions.This is smallest segment contributing less than 10% to bottom line.

I don't want to bore the readers with in-depth study of the business model but please do have a look at the company website and annual reports regarding its business strategies and the like.

FINANCIALS

Sembcorp Industries 5-year Summary

The 5-year financial summary seems to show that on aggregate, the company is performing reasonably well in terms of revenues and earnings. The free cash flow is pretty lumpy as expected due to the capex heavy nature of the marine industry as well as the growing phase of the utilities business. Something that I don't quite like is that the company is currently in net debt and with debt/equity ratio of  65% - but I argue that the overall earnings power is more than sufficient to finance this and the S$2200M cash on hand is definitely enough to pay out the S$930M borrowings due within 1-year. The company has been paying dividends as far back as more than 10 years ago and the past 5 years shows a payout ratio of about 30%-40%. Assuming dividends is maintained at S$0.17, yield is about 4.1%.

Another worrying trend is the decreasing ROE from 20.6% to 15.7% over a period of 5 years. A 15% ROE is still pretty good in general but its also good to pinpoint the reasons for the decline.

Sembcorp Industries Segment ROE

Obviously, we would prefer a business that is able to at least maintain its rate of return whilst employing incremental amounts of capital for expansion over an extended period of time - the Utilities segment is one good example. From 2009 - 2013, while using increasing amounts of capital, ROE for the Utilities business is relatively stable fluctuating between 15.6% to 19.6% while Marine is showing a consistent decline from 38.2% to 20.8%. Kudos to the Utilities segment in this aspect. Of course, we can't discount the fact that Marine's current rate of return is still very decent, but its inability to maintain this may be a cause for concern.

Perhaps a 10-year summary can provide a more meaningful insight of Sembcorp Industries 2 core operations:

As can be seen, both segments registered huge growth in both revenue and net profit over the past 10 years. The clear winner here is no doubt the Marine segment having registered 420% and 259% growth versus Utilities at 140% and 183% growth in revenue and net profit respectively. Are these growth sustainable enough for the analyst to make a decision with regards to its earnings power?

10-year Revenue & Profit Chart for Utilties & Marine

A look at the chart above shows that in general, the earnings of the Marine is volatile especially since 2007 while that of the Utilties segment is more stable, with earnings contribution surpassing the Marine segment since 2012.

10-year Net Profit Margin Chart for Utilities & Marine

The 10-year period net profit margin confirms this view point. Although the Marine registered a higher average net profit margin (7%) than Utilities (6.2%) over this period, the Utilities segment's margin is more stable at between 4% to 9% versus Marine's 3.5% to 11.5%. Do note that the 9% margin achieved in 2013 includes non-recurring income which when adjusted, should bring it lower to about 7.5%.

It is not wrong to say that due to the nature of its industry, typical utilities businesses are quite stable. For Sembcorp Industries, with the support of the statistical exhibits from the revenue, earnings, ROE and Net Profit Margin, I argue that its Utilities business is inherently stable and because of this predictability and stability, the Utilities business warrants a higher valuation as compared to other businesses. For the Marine segment, because of its dependence on order book & oil prices, coupled with its statistical showing, we can't for sure say it is a stable operating business. But based on its leadership position in its industry and strong features like ROE, it is also unfair to conclude that it is a lousy business that is worth a very low valuation.

VALUATION

On 8 Dec 2014, the market cap of Sembcorp Industries is about S$7500M while that of Sembcorp Marine (listed separately with code: S51.SI) is S$6100M. Sembcorp Industries owns 60.7% of the Marine business. With this, the implied valuation of Sembcorp Industries excluding its stake in the Marine business is S$3800. This necessarily means that the market is valuing the Utilties and Others segment at a low P/E (2013) ratio of  7.9x. That's really quite interesting.

Originally, I would prefer to use cash flows to value Sembcorp. However, the free cash flows are not very consistent owing to the heavy capex required, presumably for future growth. Coupled with the lack of guidance in estimating maintenance capex, perhaps its better to value the entire business on an earnings basis.

Utilities Valuation

Removing one-time items from the IPO of Sembcorp Salalah in Oman and impairment charges at Teeside in UK, the adjusted 2013 earnings would be about $$380M. As shown above (table and chart), the Utilities segment has shown sustained growth in revenue and earnings in the past decade. We know that this segment is still in the midst of expansion and track record has shown management to be prudent in this aspect.. From this, I think its fair to say that 2013 earnings for Utilities is a nice guide for future earnings. At what multiplier should be fair for this segment then?

Sector P/E extracted from Gurufocus

I shall now run the risk of being criticized by fellow investors with the following. As seen in the Sector P/E extracted from Gurufocus, the P/E ratio for Utilities segment in S&P 500 is about 22 (Yahoo Finance shows similar numbers). Of course, S&P 500 concerns the US market plus the current P/E provided may be a poor indicator etc and there are other valuation methods. But for simplicity's sake, i decided to use this as a reference. I had also alluded above that because of its business characteristics and strong statistical showing, the Utilities business is inherently stable and probably deserves a high valuation. I'm not going to use P/E of 22 for the reason that its way too high. Of course, P/E of 10 is unfair too. A reasonable estimate should be probably about P/E=15 which means the Utilities segment is worth about S$5700.

Marine Valuation

The Marine segment is in a relatively volatile business affected by things like its orderbook, oil prices and sentiments. What I am looking here is for a long-term average of what Marine can consistently earn in the future. Perhaps its better to normalize the earnings and take the average result of the past 10 years, giving us an earnings power of about S$285M. A long term P/E of about 12-13 should be decent enough for a company like Marine, considering its long operating history and track record, despite its supposedly fluctuating business environment. This means that Marine is worth around S$3550M.

Adding them together, the Valuation should be about S$9250M (or price of about $5.15) as compared to current market cap of S$7,565 implying a margin of safety of 18%. I've decided to ignore the Urban Development segment since it probably is too small (for now) to affect the overall valuation significantly (I'll consider it as an x'mas gift).

True, the business is currently priced in the market above its book value and on this basis some may feel it is liberally priced. However, accounting treatment has its own constraints and certain non-quantifiable information such as Sembcorp's strong reputation, customer relations and capacity for innovation is not captured directly in the financial statements. I believe these intangibles is definitely worth something for Sembcorp (unlike many companies out there) but I hesitate to come out with a value. Anyway, compared with many blue chip companies, a price to tangible book of 1.5 is actually quite low. As an ongoing business, it is usually the earnings power of its assets rather than balance sheet valuation that really counts and based on these considerations I'm comfortable with the above indicated valuation.

SHARE BUYBACK

Sembcorp Industries has been buying back shares recently. However, a quick check at the total shares outstanding for the past years does not show a decreasing trend. This is likely due to the company's policy of issuing stock options. There's not much to conclude about the value of the company here.

It is worth highlighting that a director of Sembcorp Marine has bought some shares during the recent price decline, possibly indicating that Marine segment is undervalued as well.

CONCLUSION

Sembcorp Industries is an industrial conglomerate with its core operating business earning a decent return on capital. Based on the market price of Sembcorp Marine, the implied valuation of the market clearly undervalues the Utilities segment. An investor who wants to take part in the undervaluation of the Utilities segment probably could buy Sembcorp Industries and correspondingly short an equivalent proportion of Sembcorp Marine. However, I prefer not to bet against the Marine segment. Looking it at another point of view, buying shares of Sembcorp Industries could bring about a natural industrial and geographical diversification from the Utilities, Marine and Urban Development businesses.

The concern here is whether the margin of safety is enough to justify a purchase. I'm here reminded about a similar concept (we call this 'safety factor') during my university days studying Engineering. To put it very simply, we were taught that if the consequences are severe or gravely (For eg, when building a bridge for cars and which may involves lives of many people), the typical safety factor should be high. Similarly, if we were to build a chair (that probably won't kill someone if it collapse), a small safety factor should do fine.

For a company like Sembcorp Industries, I believe we don't need too high a margin of safety to justify a purchase. 20%-30% should be fair enough. However, this is not to say that a margin of safety as low as 5%-10% is sufficient. This would mean that investors who bought at about S$5.00 even though Sembcorp Industries dropped from a high of S$5.50 may not be putting their money to good use.

All in all, I believe this analysis is consistent with our stock investments philosophy (read more about it here) and should do quite okay in the long term. I'll really appreciate if you can share some insights about this company. Thank you!


Disclosure:
Long Sembcorp Industries (U96.SI) @ S$4.15 with the hope it'll go down for further accumulation
No position in Sembcorp Marine (S51.SI)