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.

Avi-Tech Electronics (CT1.SI) – Is Quick Profit Possible?

In my post on My SG Portfolio 2014 and Some Recent Picks, I’ve mentioned that one of my event-driven picks for 2015 is Avi-Tech Electronics. I think price then was about S$0.074 and I’ve accumulated since November at an average price including costs of S$0.699. There are some interesting comments in the post (you should read it here) and I thought that probably it’s good to write a short article about my analysis.

Avi-Tech Electronics is listed on the SGX and is a provider for Burn-in, engineering and manufacturing services in the semi-conductor & electronics industry. In 2011, It ventured into the Imaging Equipment and Energy Efficient Products by starting 2 subsidiaries to ‘diversify and substantiate long-term growth’ for the company. Guess what happened in the end: since 2011, the company began incurring losses largely due to these same subsidiaries and management has finally decided to discontinue these operations just a couple of months back. Originally, the classification of this type of purchase in my portfolio (see post for more details about this) do not require intensive analysis – so I’ll try to keep things simple here. The following data are based on my 30 Dec 2014 post:

Price = S$0.074
Shares outstanding = 342,422,096
Market Cap = S$25.34M
P/E = NA (losses)
EV/EBIT = NA (losses)

P/NTA = 0.63

Investment Thesis

The results in this classification of stocks depend a lot on corporate events which in some sense serve as a catalyst to close up the price-value gap, hopefully in a fairly short period of time. My investment decision is premised on the following: 

1. The management has destroyed huge value over the years from the 2 loss-making subsidiaries. Many shareholders could have loss confidence with management's ability and decided to sell / cut losses.
2. The poorer fundamentals and financial results combined with the inclusion onto the SGX watch-list due to 3 consecutive years of pre-tax losses has led to a stock price decline that is likely over-exaggerated.
3. This exaggeration led to a fair degree of undervaluation which also means a potential investment opportunity to the shrewd analyst.
4. Directors have been mopping up shares recently with their own money and to that extent, agreeing with my view that the stock price might be undervalued.
5. The disposal of subsidiaries which are main contributors of past years' losses may improve future earnings at least in the short term and this may prop up the market price.

Key Risks / Uncertainty

Management indicated that they will “continue with its plans to seek new areas of growth whether through mergers and acquisitions, or any structured transaction or business, which will add value to shareholders.” Has management really learnt their lesson from previous experiences? Are they capable enough to continue ‘adding value’ through acquisitions? Personally, I feel its foolish for them to do that considering their core business ain’t doing as well as before too (more details below).

Also, we can’t deny the fact that they are in a difficult semi-conductor industry which presents a challenge to the management (that is perhaps why they insist on growing through acquisitions etc) and a risk that the investor need to be wary of.

Safeguards and Checks – In case things do not turn out well

Like I say, the need for intensive analysis is not really required for the event-type part of my portfolio and I hope to realize some profits in a reasonably short period of time. However, as a safeguard, I better ensure there’s some sort of margin of safety if things don’t work out and I might have to hold on to it for a longer than expected timeframe. Since this will be a minor position in my portfolio, a brief analysis should be sufficient.

Financial Position

The balance sheet is generally cash rich with net cash equivalents of about S$23.5M which compares favorably to the market cap at S$25.3M. Book value is about S$40M. If the company is liquidated now, I believe we can get back more than what we pay now. Of course, if management continues eroding value by doing foolish expansions, the intrinsic value on a liquidating basis may drop below our price paid in light of such later developments in the business. 

Earnings

Avi-Tech Electronics Financial Summary

I’ve cleaned up the effects of the loss-making subsidiaries in the above table and it is clear that these subsidiaries have indeed eroded earnings between 2011 and 2013, before management decide to discontinue operations in 2014. The core operations haven’t been doing well too considering that they also have registered some losses between 2012 to 2014. Core business revenue has declined drastically from S$70M to S$23M over 7 years.  However, keep in mind that the bulk of the negative earnings is attributed to the subsidiaries (contribution by subsidiaries is -S$12.8M compared to +S$1.7M for core business from 2011 to 2013). 

Valuation

Not surprisingly, thanks to these loss-making subsidiaries, share price has declined more than 60% since 2011. The discontinuation of the subsidiaries has stemmed losses greatly and results in 1Q2015 shows a positive profit. Could there be turnaround which can lift share price higher? No one can say this for sure.

Avi-Tech Electronics 5 Year Stock Chart

Let's use 2010 and 2015 results for comparison since in both years, the loss-making subsidiaries are non-existent. A back-of-the envelope calculation shows PER of 2010 is about 15.6X while forward PER of 2015 appears to be about 9.1X (I annualized 1Q15 earnings per share of S$0.002 here as an approximation). Assuming all else remains the same, this could be another indication that share price decline has been exaggerated and the market probably has not factored in the positive effects from the disposal. If valuation in 2010 is any guide, the market price should be priced around S$0.12! Of course, I’m not saying these assumptions are reasonable but at least it gives me some level of comfort here knowing that I'm not buying at a ridiculously high price.

Because the earnings has been quite unstable, probably the balance sheet can give better insights about its intrinsic value. Taking a haircut of 50% to PPE (NB: this part of the balance sheet is throwing in some S$500K-S$700K rental income annually), 25% to inventory and 10% to receivables, we get a liquidation value of S$0.094 per share as compared to the price of S$0.074. (Potential Bonus 1: I did not include the proceeds that the company may receive from the disposal of subsidiary in this valuation).

Conclusion

A high price can turn stocks of good quality businesses into a speculative purchase and likewise, a low price can turn a speculative stock into an attractive investment. My opinion is that Avi-Tech belongs to the latter. Considering the pros and cons, I think the low price coupled with the existence of potential catalysts make the purchase of Avi-tech too attractive to be denied by the security analyst. However, the risks mentioned above also means that the sizing of the position in the portfolio should be kept relatively small - just in case management screw things up again. (Potential Bonus 2: we already ensured there's some margin of safety to absorb unfavourable future developments but what if by some freak nature, the future acquisitions are so successful that future earnings improve dramatically? This is definitely not accounted for yet).

Some Final Thoughts

Due to it’s classification in my portfolio & unless there’s any clear-cut change in circumstances, my guess is that I will take most of my profits (if any) within the next 12 months. I mentioned that my average price purchased including costs since November ‘14 is S$0.0699. Price now at S$0.078 would mean that my current returns is about 12% in slightly less than 2 months. Obviously this is not the best business in the best industry and I have the urge to take my profits initially when it was at S$0.08. After some deliberation, I figured that my estimate of S$0.094 is really a minimum valuation which is so conservative to the extent that it is a reasonably dependable guide. Moreover, one of the directors bought back shares a couple of days back at about S$0.078. Maybe somewhere around S$0.09 I can consider trimming my stakes. I would be more than happy to get some opinions about this.

PS: I’m surprised that I took about an hour of analysis before my decision to purchase Avi-Tech but it took me more than 3-4 hours to write it in this blog!

Disclosure:

Long Avi-Tech Electronics  (CT1.SI)

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)

Our Stocks Investment Philosophy

Analyzing and investing in stocks have been my passion for years. Personally, I feel it is one of the rare few endeavors that taps into our logical, mental and emotional faculties. At the end of the day, not only do we understand how things work in a business but we began to understand more about ourselves and our biases as well as our friends and family members whom we interact with in making investment decisions.

Below are some reasons why I decided to start this blog. Throughout the blog, you will notice that I like to use words like 'we' or 'our' to give credit to people, friends, authors and investors who gave incredible insights to a particular investment concept, business or a specific company during the process of learning, interactions, discussions and research.

The underlying purpose of this investment blog is mainly to:

1) Briefly summarize our investment thesis and pen down our thoughts in a simple and coherent manner

2) Keep track of the main reasons that we feel justify our initial purchase in the shares of a particular business

3) Reinforce and relearn investment concepts

4) Subject our theses to scrutiny and feedback so as to gain new insights in our investment journey

Our Stocks Investment Philosophy

Security selection requires a skillful balance between the facts of the past and the possibilities of the future. This can be attained through the use of right strategy and knowledge, keen awareness about one’s own emotional and logical faculty in making judgments and decisions as well as experience.

A brief summary of our investment framework which we adhere to are as follows:

A Business Perspective  

This is the core philosophy that encompasses all others. We view a stock as a piece of a business and in doing so, we remain focused on the cash the business will generate and on its financial position as opposed to the opinions of other investors in the market. Both the statistical exhibits as well as the qualitative background of the company are examined. We make sure we understand the business to a reasonable extent before proceeding.

Conservative Valuation

If the business passes our initial analysis, we will estimate how much the business is worth commensurate to its assets, earnings and dividends. The valuation should mirror closely to what a knowledgeable and prudent businessman will pay if given an opportunity to invest in the same business over which he could exercise control.

Margin of Safety

The unifying theme here is that we try to buy things on sale - our opportunity comes when we can capitalize upon a favorable difference between price on the one hand and indicated or appraised value on the other. Margin of safety is both a source of potential profit as well as downside protection.

Diversification

Because the future is uncertain, the margin of safety is not a guarantee of profit and hence the need for diversification to better capture individual probabilities of profit potential as well as spreading unsystematic risk.

Patience

We do not presume to know when or to what extent we will be rewarded for identifying a security that is mispriced in the market but we know from experience that most will eventually. Because we don’t know when, we take most positions with a long-term perspective and this necessarily requires patience. A catalyst is a bonus but not compulsory during the decision-making process.

I'll be extremely interested to know from you guys what are the other qualities or features in your investment process that you feel is indispensable and should be included in the overall investing framework. Do leave your thoughts in the comments section!

AP OIL (5AU.SI) - A Neglected but Cheap Stock in Singapore

AP Oil (Company Website) is listed on the SGX and its main activities consist of 3 segments:

1. Manufacturing of a range of lubricating and specialty chemicals for industrial, automotive and marine applications under the group's own brand names.
2. Trading of base oils, additives, chemicals and some related 3rd party products.
3. Franchising which includes trading in raw material for products under the company's brand name. 

Their products are marketed to some 20 countries including Singapore, Bangladesh, Myanmar, Vietnam and others. What attracted me to this company is its relatively strong asset backing as well as ability to generate solid operating earnings and free cash flow. Also, throughout the company's more than 30 years of operations, it only suffered one year of loss which is due to one-off losses in a new business venture. Some key metrics are as follows:

Price = S$0.191
Shares Outstanding = 164,531,172
Market Cap = S$31.43M
P/E (ttm) = 7.0x
P/NTA (mrq)= 0.74x
EV/EBIT (ttm) = 4.3x
ROE (ttm) = 10.9%

AP Oil Financials

Having a P/NTA of 0.74x may not be spectacular but I would like to highlight a few things. The first is that the balance sheet is pretty clean and liquid, with net cash of S$20M (1H2014 Results) or S$0.12 per share. This compares quite favourably with the current market price. Secondly, a close look at the statements shows Associates contributing about $650K to the bottom line while it is booked at $2.9M. If a knowledgeable businessman were to buy this part of the company, I believe they would probably pay at least 7-8 times of its earnings (i.e. about $5M). Lastly, management is able to grow its book value consistently at a compounded rate of >10%/year since 2002 when the statements are available.

Statistically, we see that the earnings and free cash flows are on average, relatively stable and consistent. As alluded above, the trailing ROE is 10.9% and has decreased significantly from 22% in ’09. However, if we adjust for the low returns due to the huge excess cash horde, it should be higher (we estimate it to be in excess of 14%).

The company pays out 10-20% of its earnings, giving a relatively mediocre yield of about 2.5%. The only consolation is that the company has been paying dividends since 2010.

AP Oil Business

Now, we're no genius in the petroleum lubricating or specialty chemicals industry. Much of the qualitative aspects of the company should be reflected into the financials. Since there’s no easy way to ‘quantify’ its quality, our main concern is whether or not we can count upon the company to remain in business like it has before in the foreseeable future.

Other than the usual risks like fluctuation of raw material prices etc (which AP Oil has proven to manage quite well overall and our guess is that the current low oil price bodes well for its bottom line), the key business risk is the concentration of its major customers. The top 2 customers contributes about 40% sales in 2013 and the top 3 about 59% sales respectively in 2012. This got to be a big minus. As a sort of counterbalance, the company has plans to grow market share in existing markets and foray into untapped new territories. Hopefully, this will introduce both customer and geographic diversification. With its strong financial position and experience, AP Oil is well poised to take advantage of further expansion opportunities.

AP Oil is likely to enjoy regular recurring sales from repeat clients. Firstly, the lubricants and blended chemical are expendable products and secondly, it is hardly ‘postponable’ (i.e. once it’s being used up or expended, they need to replenish it pretty soon). Also, our guess is that for some applications and clients, these products form a small part of their budget and it is quite unlikely for them to actively source for another supplier.

Lastly, some products are non-standard and require certain R&D and technical know-how. When a customer orders a product to meet specific requirements, R&D is required to develop a new formula to meet these requirements. Note that AP Oil will retain ownership of the formulation which builds on its existing knowledge and database. In some cases, customers provide sensitive formulation owned by them (which may be sometimes a positive too in terms of customer retention).

AP Oil - Valuation

It seems that AP Oil is a pretty solid business with decent assets backing. Is the company undervalued relative to the market price now? 

As mentioned, AP oil consists of 3 segments. The financial reports separated their individual revenue and gross profit contributions (all 3 segments are still positive here) but lumped all the expenses together. Thus the best way to value the company is by considering the whole.

With its predictable & stable results, it is not hard to have a conservative earnings power estimate for the company of about $4M, which is lower than the past 5 years as well as the TTM results of $4.5M. Despite having a relatively simple business model, nice track record, potential for growth and strong financial setup, I hesitate to give a high multiplier due to some key risks I’ve discussed earlier (I'll probably touch more on that in my future post). A 9-11x multiple should be good enough. Adding to our $12M estimate of net excess cash, the valuation becomes $52M or $0.315 per share. Comparing market price of 0.191, we have an upside of 65%.

Of course, this is just a very simple but in our opinion, quite reasonable valuation process. Although we did test this with other valuation models (which coincidentally gives an intrinsic value range of between $0.25 - $0.35 which reinforces this estimate of $0.315) I think this is good enough. As long as the estimate is sensible and conservative, coupled with a huge margin of safety, there’s no need for an accurate figure. It’s better to be approximately right than precisely wrong.

Insider Ownership

Insider ownership is pretty high at about 50% and the management should care enough for the business to do well. The question here is do they own too much to ignore outside minority shareholders?

Conclusion

With a long operating track record, potential for growth, coupled with a price that offers sufficient margin of safety, we decided to take a position in the company. Sure, the business isn’t the best of the best but a purchase at this low price should be well justified. It's not easy nowadays to find a relatively good ROE company with low valuations. If one can find 10 companies like this, the diversified result should turn out quite satisfactory.

Disclosure:

Long AP Oil (5AU.SI)