SMRT Corporation Buyout Offer: An Alternative Viewpoint

Temasek is buying out the 'troubled' transport firm SMRT at S$1.68 - valuing the company at about S$2.56B. Because Temasek owns 54.1%, they have to pay about S$1.18B for the remaining stake.

Readers of my blog would have known I bought SMRT back in 2014 at an average cost of about $1.02 and sold the same year at $1.49. I left a comment and highlighted that the non-fare segment of the company seemed attractive as follows:

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.

Some SMRT Non-Rail Results

Let's have a look at the results of 3 of the largest Non-Rail segments, namely: the Taxi, Rental and Advertising Segment -

As can be seen, all 3 segments have shown marked and consistent increase in both the topline and operating results (total in 2016: S$123M) over the past 6 years. The total operating profit for the Rail & Non-Rail Segments is S$142.6M. That means the 3 biggest Non-Rail segment is >85% of the total Non-Rail and Rail operating results. I think it is not unreasonable to expect that the Non-Rail segments will do quite well in the foreseeable future. These 3 very profitable, inherently stable and growing segments combined could probably be worth about S$1.7B (this is only a quick and dirty estimate of 13X - 15X operating profit). Also take note that there are other Non-Rail segments that may be of some value as well (classified as Engineering Services, Other Services and Investment Holding and Support Services).

I'm not so sure why the focus out there concerns so much about the Rail segment and why the management has not expressed any thoughts on the striving Non-Rail segment with regards to the buyout offer. But from the standpoint of the investor and those who are supposed have a duty to look after shareholders' interest, it is unwise to focus solely on the Rail segment and keep harping about the Rail's corresponding risk.

There seems to be much confusion whether SMRT Rails should be more concerned with the investors' interest or the public's. Also, Chief Executive Desmond Kuek (former army general) said that "significant risks remain and many factors are outside the control of SMRT such as uncertainty over future fare increases and ridership numbers." I'm not so sure how 'significant' the risk for the rail segment is in the future despite being relieved of their heavy operating assets under the new Rail Financing Framework. I would hazard a guess that both fare and ridership numbers will at least remain stable and it is likely that operations will be less risky compared to before the implementation of the framework.

Proposed Solution

1. Since the focus of the buyout seemed to be on the Rail segment: spin out the Non-Rail segments so that their proper value can be realized by the market. Existing shareholders should be more than happy to then sell off the operations of the Rail and Bus segments not owned by Temasek for a lesser, say S$500M (this values the Rail & Bus segments to be about S$1.1B. Assuming the above valuation of $1.7B for the 3 Non-Rail segments are correct, SMRT could potentially be worth in excess of S$2.8B which corresponds to a price of about S$1.84 per share). 
2. Offer a (higher) price that truly reflects the value of both the Rail & Non-Rail segments. (I read in the news that in the past 10 odd years, SMRT's price averaged about S$1.64. Offered price is S$1.68. Obviously some shareholders might be unhappy with the current offer).

Advantages are Two-Fold:

1. Rail and Bus assets out of the way and privatized - the role of a public transport operator can be better fulfilled in the long term without taking the pressure of short-term market expectations.
2. With the Rail segment out, the market can more easily discern the true value of the remaining Non-Rail entities. Not only can shareholders receive some cash from the disposal, they would probably be very pleased to have their hands on a growing and very profitable Non-Rail segment.

Some Things to Work Out

Now, the Advertising and Rental businesses are obviously highly intertwined with the Rail business. Therefore, the question to ask is if the above solution is possible at all? I'll leave these to the shareholders and management to answer for themselves. It's tough, but a fair and equitable solution should be created for all parties involved.

Disclosure:
No position in SMRT (S53.SI) as of 21 July 2016

The Question of Dividends as Passive Income

Recently, a friend directed me to Giraffe Value’s blog post titled “Investing For Dividend Income(Passive) is a Fairytale!!!”  The angle about dividends (that they cannot be considered passive income) brought forward by GV is refreshing indeed but I believe GV has missed out some salient points and thus decided to offer an alternative perspective in this topic by commenting in his blog. With GV's knowledge, I herewith copy my comments (with very minor edits to make things more easily understood) below. It may be helpful if you first read GV's article to understand his take on dividends.

With the CD & XD effect, are Dividends paid out still considered Passive Income to the investor?

Readers of this blog would have realized my reply are drawn out of and adheres closely to the "Business Perspective" section in my Stocks Investment Philosophy in which my investment framework is based on.

Also, as shown in my reply, I did agree with some points underscored by GV. My intention here is to bring about healthy discussions in the hope of getting more clarity in this subject matter through insights and thoughts provided by readers and investors.

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Hi GV,

Good effort on your post. However, I wish to highlight an alternative viewpoint that I personally feel provides a more inclusive and comprehensive take about dividends. I believe the point of contention here is whether dividends paid out is considered ‘passive income.’ 

First and foremost, I assume that your 2 questions are valid in identifying whether passive income is involved. I would also add-on a 3rd point to make the argument more robust:

1.           Are you richer after getting that dividend?

2.           Would your capital not get compromised after you receive the dividend?

3.           Is the money received passive (as opposed to the word ‘active’).

As a fundamental investor (I think you are one as well), perhaps it is more insightful to look at holding the stock as being part-owners of the business. To avoid complication, let’s just assume that we have 100% ownership of a business. This view point can be easily extended to one who have partial ownership of the business through buying its shares in the market.

As 100% owners of a profitable business, we employ officers to add value to goods and services produced so as to generate income for us. Every dollar earned from the business wholly belongs to the owners. In the general sense, if earnings are $10M and beginning of year assets is $100M, the company is now worth $110M. Going back to the 3 questions above, It is clear that with full ownership of the business and by way of earnings generated, the owners are now 1) $10M richer and obviously 2) their capital is not compromised. Also, as the officers are the ones doing the hard work, we can conclude that 3) it is ‘passive’ in nature. With this, we can say the earnings are passive income to the owners.

The owners have the option to either keep the money in the business as retained earnings or issue the earnings out as dividends. If say, $5M of the earnings are released as dividends, the company is now worth $105M. But because the owners own the business, their net worth is still $110M ($5M dividends received plus $105M worth of business assets wholly owned by owners) which necessarily means that in totality, their net worth still increased by $10M. Is this $10M still considered passive? I argue so based on the 3 questions asked above. To the owners, these dividends are in actual fact just a proxy to get hold of the passive earnings of the company.

Your take regarding the HDB is almost exactly the same as the above scenario where it fulfils the 3 questions asked. Because in the stock market, we are partial owners of the company, we tend to consider only the dividends ($5M) and neglected the fact that the remaining $5M of the earnings fully belonged to all shareholders as well (I believe your argument missed this point too). So this $10M of earnings is akin to the rental income we get from a fully owned HDB property.

Now let’s think from the standpoint of the stock investor. Here, I would agree with you that an investor should consider both capital appreciation and dividend return but I just want to highlight that dividends in the investor's perspective are still passive income. Investor A purchase a stock a $1 and price appreciates to $2. The company subsequently declares a $0.50 dividends and share price proceeds to drop to $1.50 due to the XD effect. Investor B purchases a stock at $1 and price appreciates to $2 with no dividends declared. Both investors had a net gain of $1 from their investments. Considering both realized and unrealized gain, it is clear that they are all passive income to both investors. Having no net gain between Investor A and B does not mean there are no passive income involved.

I also agree that your left pocket right pocket - zero sum game theory makes perfect sense (but this does not mean dividends are not passive income).  Because dividends are usually paid in liquid cash out of the company, it makes sense that stock price should drop by the amount of dividends released. If not, we will find that the net worth of the investor (which includes both dividends received as well as ownership of the business) increase inexplicably. However, this effect is just a logical stock market event to ensure that - assuming other things remaining constant - the total amount of what owners received and what the business have are the same before and after the event.

To conclude, CD-XD phenomenon is just an Event which fails to explain that dividends received are not passive income but it does not necessarily mean that dividends are not passive income. Viewed in the proper way, the owner’s earnings are passive income and since dividends usually comes from owner’s earnings, they are part of the passive income in every sense of the word.

I got to your post because a friend referred it to me. Your post must have generated strong interest as I understand that there are some follow-ups in other financial blogs which mostly agree with your point that dividends are not passive income. However, I feel that if we viewed this issue as a whole, the logical (as well as intuitive) explanation contradicts the point that dividends cannot be considered passive income. We've communicated some time back and I know you are, like me, a keen learner of stock investments. Hope to hear more about investments from you.

Secretinvestors

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PS: I appreciate that readers share their views about this in the comments section below. Also, GV gave an interesting reply to this comment. Readers can refer to his blog article for that and decide for themselves which view point is more valid and logical.


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Our Stocks Investment Philosophy

The Beauty of Compounding in Companies and Its Implications

In my previous post on The Beauty of Compounding to Investors, I've discussed briefly on the mechanics of the simple compound interest equation and concluded that the best way for an investor to optimize its use is to identify each factor (starting capital, compound rate, time period) in the equation separately and work on the weaknesses (especially those that is easily within our control) so that the integration of all 3 factors can hopefully produce an exceptional result. In this post, I'll talk more about this effect on companies and try to relate it to the individual investor.

Case Studies & Assumptions

Let's use some of case studies for Company X (if you are curious about the company's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - Let me know by commenting below or emailing me at secretinvestors@gmail.com when this is done). As usual, to make things simple, some assumptions have to be made for the model:

1. In the actual case, Company X managed to grow its book value by compounding it at >10% annually for the past 12 years. Here, we assume that this growth rate will continue for the next 5 years. Book value now is $0.25 per share.
2. Assume book value is a reasonable estimate to intrinsic value of the company and the market price of its stock will converge to its intrinsic/book value at the end of 5 years.
3. No other forces (inflation etc) are at play that will skew the final results.

4 scenarios will be used here (please note again that book value for all scenarios is $0.25 per share):

• Scenario A: Market Price: $0.20 (20% discount to book), Growth rate: 0%
• Scenario B: Market Price: $0.30 (20% premium to book), Growth rate: 10%
• Scenario C: Market Price: $0.25 (at book value), Growth rate: 10%
• Scenario D: Market Price: $0.20 (20% discount to book), Growth rate: 10%

Summary of Scenario Results

Scenario Capital Appreciation Results (Dividends not factored in)

Comparing Scenarios A & B, we see that despite paying at 20% premium to book value (for B), the stock investor is still able to turn in better results compared to one who bought at 20% discount to book value (for A) - provided the growth rate is high enough. In this case, a quick calculation shows that a 4.5% growth rate in Scenario B is sufficient to get the same 25% results achieved in Scenario A.

Comparing Scenarios C & D, it is clear that although the purchase price of D is only 20% lower than C and both have the same growth rate, D turns it significantly higher results (much more than 20%). All in all, Scenario D gives the best results. For your info: Company X is currently priced below that of Scenario D now, indicating a better upside if we were to base it on this very simplistic model.

This is a very simplistic view of the compounding effect but it does show the powerful snowballing effect of the compound equation. The key limitations are obviously in the assumptions. In the first place, we can't know for sure whether the book value or 'intrinsic' value can grow at 10% for the next year, save to say for 5 straight years. Also, there are definitely many other factors or uncertainties at play that will affect the final result. Lastly, for most companies, the book value does not equate to the intrinsic value. Even if they do, the market price may or may not converge to this implied intrinsic value at the end of 5 years (it could be earlier or later). Despite these limitations, I believe its good enough to show the compounding effect and its implications to the stock investor.

The Ultimate Approach - Dual Margin of Safety

Margin of safety is an important part of our overall investment framework as discussed in the post on Our Stocks Investment Philosophy. The above exhibit suggests 2 key ways to profit from the stock market. First and foremost, the investor can purchase securities at a price that is currently at a discount to a readily ascertainable intrinsic value as in Scenario A. This discount is in itself a margin of safety. Alternatively, the investor can purchase the security at a reasonably fair price as compared to the current intrinsic value but he or she must be confident that the future prospects or growth is so good that it is sufficient margin of safety for a profit to be made, as in Scenario C above. 

The best approach to stock selection is of course to find securities that meets both criteria or approaches discussed in the previous paragraph - by having a discount to current value and potential growth that can further increase this value in the foreseeable future such that the cushion in price-value gap widens further over time. This is similar to Scenario D in the above table which as shown, give the best results out of the 4.

I will discuss further about the obstacles in execution in the application of the Dual Margin of Safety approach and end off with my proposed solution. Let me know if there's alternative methods or approaches that you've been doing that has been consistently successful ya?

Disclosure:

Long Company X - Do you know which company is this?

As mentioned, if you are curious about Company X's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - When this is done, let me know by commenting below or emailing me at secretinvestors@gmail.com :-)

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

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein.

I’m always amazed by the mechanics and impact of the compounding effect. The basic compound interest formula is:-

Where:

F = Future value or final value of the investment
P = Principal or the starting capital
r = Annual rate of return
t = The number of years this return is compounded

To let the compounding effect work its wonder, an investor needs to focus on the Starting Capital (denoted by P), Annual rate of return (r) and the number of years (t). Let’s use $100,000 starting capital, 10% annual return and 20 years as baseline inputs for comparisons with other permutations. For simplicity, effects of inflation are neglected throughout.

Effects of Compounding with Various Inputs

As observed from the table and chart, for all cases the value of gains is much more than the initial capital itself. But what can we really learn from these results and what can we do to maximize the compounding effect?

I find it quite worthwhile to classify these inputs based on the level of control we have over them. By identifying them singularly, we can find out which inputs we are lacking and categorically work on them.

Time Factor (t)

As observed above, time is an absolute critical factor for the effects of compounding to snowball the initial capital as much as possible. All of the input invested 7 years late did worse than the baseline input. If we have $100K and can compound 10% for 20 years but we do it 7 years later, our gains is a 57% or $327K lesser! 7 years later is 7 years too late. This is something that we can control only when we are still young. The key is to start investing as early as possible and have the patience to let the compounding effect work. 

To put it into practical perspective, if a 40 year old who earns an average of $100K per year invest with baseline results, he will have an extra $245K by 53 years old. This would mean that his investments gave him an extra 2.45 years of working income. However, if he started 7 years earlier at 33 years old, he will have an extra $570K by 53 years old which also means that he gets an extra 5.7 years of his working income. Why work another 5.7 years when you can actually get the same amount of money with less effort? Retiring a few years earlier is certainly not bad at all!

Starting Capital (P)

The Starting Capital is also important but comparatively less controllable. Different individual profiles will have differing amounts of starting capital to invest. Most of the time, we can’t really control how much we have at the start (especially when we are young). However, all of us have universal control in terms of the proportion of our money we set aside to save and invest. This is a definitely a decision that can be made and acted upon for almost everyone.

Return Factor (r)

Can we really achieve 10% returns per annum for our investments? No one knows. Sometimes its luck and other times it may be because of innate talent. I believe the best way to potentially improve anyone’s returns is through continually seeking and acquiring investment & financial knowledge. This is definitely something within our control. There are many books, articles and videos online and offline that teach us how to make our money work harder for us. Of course, this takes time and effort but I think it’s the only way to handle this factor properly.

The Real Trick – Combining All 3 Inputs

What’s the use if we can earn an impressive return from our investments but we can compound it for only 2 years? There’s also little use when we have 30 years to compound our money when we can only achieve a 2% return. The real trick lies in combining all 3 inputs in the compound interest equation. To do this, we first need to tackle each factor separately by (a) Identifying which factor we are lacking the most, (b) Find out what we can do that is within our control to improve the factor, (c) Work on improving them and (d) Repeat the process again starting from part (a). Let me know if you have other ways to optimize the compounding magic :-)

Note: Just want to highlight that there’s another factor that is not included in this simple compound interest equation. That is the additional cashflows you can add into your investment sum every period. Imagine you can compound 10% in 20 years with a starting capital of $100K and on top of that, you are also able to contribute another $12K into your portfolio annually - Your final value would be $1.36M with a contribution of $340K in total. This is compared to the baseline case mentioned above with $672K final value and $100K contribution.

This post is longer than expected. I’ll talk more about the companies which can continually compound their value through time from an investor's viewpoint.