Thursday, January 28, 2016

Lessons Learnt: Sembmarine and Keppel

Our beloved oil rig manufacturers had suffered a catastrophic decline in the last 18 to 24 months. Keppel fell from $10 to $4.8, a 52% drop and Sembcorp Marine collapsed from $4.5 to $1.5. a 66% free fall. Sembmarine's parent Sembcorp Industries didn't do that well either, falling from $5 to $2.2, again a more than 50% decline from its peak. All three stocks now trade below book, with single digit PE, with no recovery in sight. Apologies to anyone who had took advice from previous posts and bought these stocks.

Investing is as such. 40% of the time we get things wrong. With discipline and experience hopefully our wrongs are just 20-30% drops while our rights are home runs at 2-3x, which makes the overall portfolio return decent. Once in a while we would get these disasters. Then it's vital that we learn our lessons, take down good points and become better investors with them. This is the objective here today.

The original thesis with Keppel and Sembmarine was quite simple: it was a bet on energy, they were top global players in their field and they had exposure to growth in Brazil, US, North Sea, Middle East, which were growing very well not too long ago. Let's elaborate on these points:

1. Energy was the place to bet a few years ago. We have all been taught that we would run out of oil in time. I remember the limit was 20 years when I was a student 20 years ago. My teachers told me that the world would run out of oil in 20 years. Again that prediction did not come true. But it would also be true that we wouldn't have more oil right? Well we now have LNG and shale gas but still, it's not sustainable to just keep digging from our planet. Considering the growth of global economy, it's probably not incorrect to think that we cannot continue to rely on Mother Earth for fossil fuel forever. So the energy bet should be a long term positive return bet, we will run out of oil, oil price will skyrocket, Keppel and Sembmarine benefits from that. In theory.

An oil rig

2. Global #1 and #2: These two firms are the top manufacturers globally with combined 60% market share in oil rigs and they also have the technological advantage to do more. Both firms also started building other equipment like drillships and floating platforms. They also had very good global brand names and won large orders from Brazil, which unfortunately became the major cause of their downfalls. With dominant global share also meant that they had economies of scale, they could procure raw materials cheaper and could built the final products at lower costs vs their competitors. One very important factor that was not talked about was also the designs of the rigs. There are only 3-5 designs globally and both firms went to acquire these design firms years ago to make sure that the important ones would be kept in-house. This meant that future competitors i.e. the Koreans and Chinese would not be able to lay hands on these superior designs. They had to buy from the the remaining 1-2 independent designers out there which meant higher costs both for the design payments and the construction of inferior rigs. So we are betting with the winners, what could go wrong?

3. Betting into Brazil, US, North Sea and Middle East. It's always good to diversify our bets and it came as a good idea to be able to buy Singapore firms that had exposure in some of the fastest large growing economies. Again, that looked pretty good just a few years ago. Now the collapse in oil as well as other issues caused a lot of these economies to face serious growth impediments. It's consensus now not to invest in these markets at least for the next few years. 

So it was really a perfect storm. A metaphorical oil rig blow up like the one BP had in the Gulf of Mexico. Well, so much so for the past, what are the lessons learnt and what could we do better?

The biggest overlook here would be the crude oil price cycle and oil related heavy equipment investment cycle. While it's true that the world is short of energy and would likely be even more short going forward, it's also true that such cycles come and go and across decades. The following chart shows the prices of crude oil going back to the 19th century. We can see that crude cycles last for decades. Of relevance in recent times, one would need to look at the oil shocks in the 1970s and the long lull in the 1990s.

Long term crude oil prices

So analyzing Keppel and Sembmarine's ten or even twenty years of financial statements wouldn't be enough. We would need to see what happened in the 1990s and better to go back to the 1970s during the oil shocks. Obviously, that's a lot of work given that most readers here might not had been born in the 1970s. So while looking at the free cashflow (FCF) for Sembmarine from the late 1990s we see that the firm could do SGD 100-200m per year, this was not enough information. Looking back long enough, we would know that oil capex cycle could be as long as 15 to 20 years. There could be a period of time of maybe five years or more when these firms had mediocre or no FCF. Armed with this info, it looks like Sembmarine could be stuck in this state for the next few years. So that's the first lesson, not going back into history for long enough.

The other lesson learnt would be the most important lesson in value investing: it's not having enough margin of safety or MOS. When it was first proposed here that these are interesting stocks to look at, Keppel was around $8 and Sembmarine was around $3. They had fallen 20-30% from their peaks, FCF was strong based on the last few years, dividend was decent as well. Back then, the thinking was that, for these bellwethers in the Singapore stock market, getting a 3-4% dividend at mid teens PE were probably good deals. This was very gullible thinking with very little margin of safety.

Value investing doctrine taught that margin of safety should be at least 30%. Clearly with only 20% discount from all time highs didn't cut it. It didn't help that these were not staples or software, ie businesses with very low capex needs and high ROIC. These businesses were cyclical with different dynamics. Greed and exuberance in good times were culprits too. 15x PE looked cheap in bull markets, not across cycles. Well, markets are fair and whatever lessons that weren't learnt well enough would be taught again. So with oil prices crashing to $30 and these stocks falling over 50%. This margin of safety lesson come right back to haunt. So it's worth stating here in bold again: the three most important words in value investing is margin of safety.

Investing is as such, the future is unpredictable. Who would have predicted just a few months ago that oil would crash below $30? But having said all that, there are a few saving graces. Oil could easily rebound to $60 with some catalysts: be it Saudis cutting back production or some supply shock somewhere. Punters would drive these fallen angels back up a good 20-30% if oil rallies 100% (from $30 to $60). So that's a short term plus albeit a big "if" for oil to rally back to $60.

Also, other parts of the long term thesis remain intact. They are still the strongest players out there and they will emerge stronger in the next cycle even though it's far away. The Koreans and Chinese would fall further behind given the lack of scale and access to the all important rig designs. There could be value emerging now amidst all the doom and gloom. What's more, the firms themselves are not sitting still. There is now talk that Keppel will be reorganizing the whole group including divesting other parts of its business to unlock value within the group and also to raise efficiency. This would create both cashflow and increase its market value. 

For Sembmarine, it is rumoured that its parent Sembcorp Industries might buy it back and restructure it to become a stronger player. So it could be a buy for both entities. It's a buy for Sembmarine as the parent would likely pay a 30% premium to take it private but it's also a buy for Sembcorp Industries because they would be able to acquire a good business cheap and ultimately extract some value by creating cost and sales synergies. All three firms are now trading at 8-9% FCF yield on normalized FCF, below book and near their GFC lows. As the saying goes, it's the darkest before dawn. Hope that the light shines on our oil rig builders soon.

Last words: Lessons learnt help us become better investors over time. Hopefully this serves to remind us always to look back into history for as long as it takes, have enough margin of safety and think more holistically about cycles and capex businesses.

Monday, January 04, 2016

Happy New Year! Let's talk about REAL Investing!

Happy New Year folks, it's 2016. This year is meaningful in a way since this site started out in 2006. So, a decade just whizzed by with some intermittent writing, some charts and lots of thinking and oh yes, thanks for supporting this site for the past 10 years! It's been great so far, and there's another 40 more years to go! We are on track to at least match Berkshire or SG50, and it so happened that Berkshire is actually as old as Singapore and celebrated its 50th anniversary in 2015. So in 2056, we shall have 8PA50 or something. Do hang around! 

Today we would like to discuss some interesting notions about investing, and hopefully correct the layperson's perception of what real investing is all about. To most people, investing likely equates to making money in a money's game, which is linked to trades, making good speculation, being some hotshot trader, like those protrayed by Hollywood, especially in the film Wall Street starring Michael Douglas. In the Singapore's context, some might remember Da Shi Dai, or The Greed of Man, an epic Hong Kang drama series about stock manipulation that propelled a few young actors back then to stardom, like Liu Qing Yun and Vivian Chow.

DVD Cover for Da Shi Dai

Well real investing is nothing like what was portrayed in dramas, movies etc. But the images stuck. Today, when we think about investing, we probably linked it to all of the above: speculation, manipulation, big money game making the rich getting richer etc. Most would think it's a good way to get rich quick. Singaporeans, luckily or unluckily, get exposed relatively early, like in universities but soon learnt this game is really not that easy. Armed with some rudimentary knowledge, a desk and buying a PC for this purpose, we think we could make big bucks. Aspiring one day, our desks would look like those portrayed in the movies. Maybe like the one below:

A dream desk

A desk full of screens, with live prices and we become some hotshot investors sitting in plush chairs. That's the image for most people perhaps. They think that an investor's job would be to monitor markets day in day out, keeping updated with real time news, understanding price movements, making lots of trades, looking smart. Sorry, that's all just in our heads. None of these are close to any truths. A real investor's desk looks like the one below:

Warren Buffett's desk

For Warren Buffett, he doesn't even have a PC although most modern investors today do have a basic one, for news, excel and online trading. The truth is, an investor's job is really to read and to think. Hence the real desk would be filled with books, reports, newspapers, magazines more reports and more things to read. Then we have the all important thinking tools ever invented: the pencil and the paper. That's the truth. That's real investing. Okay today we need Excel to crunch some numbers, but when we do reach for Excel, the bulk of the mental work is over. Hence the real job is to read and to think. To think better that all the amateurs out there. In order to achieve that, it's also important to discuss. To challenge ourselves by talking to like-minded people, people who are smarter than us to point out our mistakes and of course people whom we love to hang out with. So read, think, discuss. If we have to surmise the real job of investing into three words. That's the three verbs.

What's so difficult then? If it's just the three verbs. Well, golf is also about swinging a stick to hit a ball, but it takes years to master right? Simple things may not be easy to accomplish. Take reading for example. Most adults today read some stuff, like the newspapers or books or magazines but to be a disciplined reader takes a different mindset and perhaps it's really a different skill set. In fact, most people would not be able to keep reading for hours on end. Personally, I find it hard to sit down and continuously read for more than an hour. And I don't recommend trying to be a four-hour bookworm to be a good investor. Maybe an hour or two per day would be enough, excluding newspaper reading. We have tons of other things to do still.

Thinking would perhaps be the hardest skill set, and it ties in with discussion. It would be easier to brainstorm with friends than to think alone. But it's not every day that we get to meet all our friends, so it might be useful to spend some time thinking everyday. That's perhaps the most important one to two hours we could ever spend. Again, it's not easy. Based on my personal experience, I usually squander these precious minutes randomly surfing the net. Before knowing it, the hour is up and I have to get back to real stuff, like laundry, or playing with the kids.

What about the portfolio? Or stock trades?

Well, the truth is, real investors don't spend too much time on these either. It's all thinking. When the time comes to enter the trade, it takes a few minutes. It cold be weeks of work done that led to the few minutes. It's just like pressing the final red button. With no drama. In fact, one value investor recommended never to put in a trade during market hours. Do it before and go to sleep. That's because the daily fluctuation of 2-5% shouldn't change the decision to buy a stock which could double or triple. The real time prices are just distractions.

As for portfolio reviews, the optimal frequency could be quarterly or longer but that's too far away for most people, so perhaps a monthly review would work but perhaps just reviewing a part of the portfolio. Long term stuff doesn't change weekly or monthly so it doesn't make sense to be doing reviews too soon. Say with a portfolio of 20-30 stocks, a monthly review on 2-3 stocks would work well. So we get back to the same stocks after 10 months. More on this on another post.

So putting it all together, a real investor could have a work plan as follows:

1. Read newspapers (at least 2: ST and FT)
2. Writing down relevant notes
3. Doing good in-depth reading

1. Read at least one magazine (the Economist)
2. Discussion with friends
3. Immerse in good long term strategic thinking

Monthly or Quarterly
1. Review parts of the portfolio (more thinking actually)
2. Consolidate relevant trades and key them in

So, that's the truth about investing. It's boring reading, thinking and occasional chats with other investors. Once in a while, we get to kick the tires, go for factory tours or AGMs but most of the time, it's desk bound and pretty lonely way to work. But if we keep going at it, someday, we get to be quite good. That's when things shine through. 

To show with a bit of a stretched analogy, we come back to one of the stars of Da Shi Dai or The Greed of Man, Ms Vivian Chow. Here's how she looked in 1990, some 25 years ago.

Vivian Chow, 1990

Most male bloggers should be drooling by now. She was the girl-next-door star in Asia back then. She couldn't sing and her acting skills were so-so but who cares? Her posters were all over army barracks and teenage boys' bedrooms. Then she got tired of show business and disappeared. Only to reappear a few years ago. Here's how she look today.

Vivian Chow, 2015

Man! She looked even better, right? So people asked, what's her secret of keeping herself so beautiful after so many years. Her answer was simple yet profound. Every day, she strives to be happy, maintain her health and smile. That's it. If we take the liberty to translate that into three relevant verbs, it might be: exercise, eat right and smile. Do enough, and we can conquer aging. Beauty is a mere reflection of our internal construct and accumulation of our daily thoughts and actions. We keep them positive, we are good.

So to be a good investor with a solid portfolio, would require, similarly, the correct internal construction: the right thinking and good ideas from daily reads, insights and also the good temperament to execute the trades free of greed and fear. The portfolio would then be the reflection of years of wisdom and compounded growth, filled with quality companies with exposure to various sectors, secular trends and themes. And it all starts with these three verbs: read, think, discuss.

A belated Happy New Year to all!

Monday, December 21, 2015

The Force Awakens: Thoughts and Takeaways

Star Wars: The Force Awakens opened last weekend and smashed all box office records. This episode, #7 in the franchise, will likely make USD 1-2bn in the cinemas alone. When Disney bought Star Wars for USD 4bn in 2012, everyone thought they were stupid. Why pay so much to George Lucas who did a crap job trying to do the prequels (Episode #1-3)? Also how can a 30 year old dated sci-fi saga be worth so much?

Now, Disney is having the last laugh. Episode #7 alone might rack in enough profits to cover the USD 4bn cost and there's five more in the pipeline. Yes, there will be Episode #8, #9 and all the way to Episode #12. The motto is: don't stop if die-hard fans will keep coming back for more. Based on my very crude Google search estimate, there could be close to a million Star Wars fan globally, counting both die-hard and casual fans. Over 60,000 of them gather for a May 4th Star Wars Celebration in the US every year.

Coming back to the math a bit more, here's some interesting revenue and cost breakdown:

In US dollar terms
2 bn Box office 
1 bn Merchandise
1 bn DVDs, streaming, rental and downloads
0.5bn Synergies from rest of Disney (Theme park rides, derivative cartoons, games etc.)
-0.5bn Marketing and cost of production

4bn Profits for Disney from Episode #7 alone

Gosh, George Lucas might be wondering whether he was underpaid. Should he have asked for USD 8bn instead? Well actually that's not entirely fair because he could not have generated USD 4-8bn if he did not have the Disney marketing machine behind it. Lucasfilm Ltd was making a miserable tens of millions from merchandise and mostly from Lego Star Wars.

Why did Star Wars do so well even after so many years? What about Disney, is it then a super investment? What are some takeaways we can learn from this? This post hopes to answer some of these questions and provide the investment thoughts as well. 

New lead characters in The Force Awakens

Ok why did Star Wars do so well? For one, pretty female leads. This instalment we have the 23 year old Daisy Ridley (that's her in the pic above with the cutesy BB8 droid) as the new protagonist, probably the prettiest amongst all the female stars. Well, Carrie Fisher wasn't too bad some 35 years ago although the bikini definitely helped. Natalie Portman was okay but Ridley really gives a fresh look despite her scavenger outfit. Okay, okay, beauty lies in the eyes of the beholder, yes and if beautiful ladies make good movies, then we won't have flops liao, ever. So it's not just about pretty girls.

Star Wars worked because it combined so many qualities of good movie-making: a popular genre (sci-fi) with a vast expanded universe, adrenaline pumping sequences, plot twists, innovative gadgets (lightsabers!) and of course the love story. Romance bring in the ladies, or at least help convince them to watch with their hubbies. Yes, there is still the luck element. The first Star Wars was really a lucky hit. It had huge production hiccups and back then, an untested plot, genre, storyline based on a Japan cult movie: Akira Kurosawa's Hidden Fortress. But when it became a success, it paved the way to build a franchise. 

We just love familiarity which is why franchises work. Today, 60-70% of the top grossing films are franchises: Harry Potter, Jurassic World, Marvel Super Heroes, Lord of the Rings and the list goes on (see chart below). This is very similar to branding, which is why we go back to the same brand of toothpastes, the same food chains, the same cosmetics and the same phones and computers which we have used before and liked it. Nobody likes to learn how to use a new OS.

Once we built a brand, we can have pricing power and pricing power is one of the most important criteria for a good investment. Strong brands can build in pricing power above inflation which is the way to supernormal profits and margins. Star Wars merchandise can be priced ridiculously and fans will just pay up. This is why Disney make billions off merchandise, not just Star Wars, but think Mickey, Disney Princesses, Marvel Heroes and all its other franchises.

Top 20 box office movies of all time

In fact, Disney has 8 out of the top 20 box office movies of all time from Marvel, Frozen, Pirates of the Caribbean, Toy Story and needless to say, Star Wars. So does it make Disney a super investment? Well it's hard to say, because it's not cheap. Disney generates c.USD 7bn in free cash flow annually but trades at a market cap of USD 180bn, that's a 3-4% FCF yield and a big part of the business deals with sports: they own ESPN which has a different business model and analysts argue that costs to acquire content (rights to live telecast sports games) are rising sharply which hurts Disney.

But in the franchise business, Disney is unbeatable. Essentially, it had become a buyer of choice for franchise creators. Pixar, Marvel, Lucasfilm all chose to be bought out by Disney because they knew their life-works would find a better home and soar to greater heights. It has become an aggregator of good quality content, not unlike Berkshire Hathaway as a good aggregator of high quality businesses. With more and more content, Disney is then able to drive more merchandise sales, more synergies between its various businesses (other than sports). 

I guess this is really one of the important lesson learnt in investing: look for good aggregator stocks. Companies that have built that capability to deliver value add by building on its strength of aggregating businesses. They just become a locus of growth and keeps attracting the good stuff to them like a strong magnet. This has been the model of growth for some US companies for some time. Especially in certain sectors like pharmaceutical and medtech.

Even in our daily lives, we can strive to be an aggregator of good quality stuff. We should aspire to aggregate wisdom in some domain and become a master of sorts (yeah like a Jedi Master). We then build a brand for ourselves and people would come to us. There are many niches that one could fulfill. I am sure we know friends who are good at music, or IT, or art, or food, or finance and we seek them out for their expertise sometimes. We should seek to be an aggregator in a field we are interested in and have established some know-how and expertise. 

Strive to be a Jedi Master

The final point I would like to make for Star Wars is the offline and online argument. This came as a revelation in 2015 as online moved to really dominate our lives after 15 years since the dotcom boom and bust saga of 1999-2000. Online and internet came one full circle in the one and half decade fulfilling the prophecies that drove the bubble then. Now we buy groceries online, pay our bills online, chat with friends online, watch movies online, in fact we can pretty much live our lives online. What does this mean for the offline world?

It means that whatever cannot be done online becomes really, really scarce and people seek to do it and cherish these rare offline moments. Every damn thing has become a commodity when it goes online so offline is left for things that are really so bloody important (or simply a hassle sometimes though if the segment hasn't caught up with the online fever, like government related matters or banking) and we will pay any price to do it offline for that experience (obviously not for the hassles though). Again, as online dominates our lives, for the really important offline events, we will pay any prices for the unique experiences in the real world.

That's watching Star Wars in the theatres. The internet has taken over the world and we can pretty much watch any movie online, paid or pirated. But if there is one movie in 2015 that you would want to watch it live in the cinemas, just like the good old days, there would only be a handful. And Star Wars would rank pretty near the top. In fact for Star Wars fans, it would be at the top. Now these fans would drag their loved ones to go with them. Or better, they would first watch it once themselves on the first day, then drag their loved ones to go with them for a second round. This explains the huge box office sales.

That's what is really happening in the real world. Since everything has gone online, what is left offline has to be really important. People will cherish the remaining offline experiences and will be willing to pay huge premiums to get these experiences. Yes, it's pricing power all over again. Think of live concerts, Michelin star restaurant meals, theme parks, birthday parties, invitation-only events and even shopping. People want to be awed when they do things offline. Hence they are no longer shopping at some local malls. They want to visit flagship stores to discover new things. They want unforgettable experiences. It's not shopping to buy stuff. We can do that on Amazon, it's about creating awesome experiences. They go to the flagship Disney store to see the Princesses or meet Darth Vader. That's shopping in 2015.

Disney understood this and embarked on an ambitious marketing campaign globally with Star Wars. We have the Changi Airport campaign in Singapore which is becoming a huge success and we see families flocked to the airport for the experiences: a photo on a life-size X-wing and another one battling the Dark Side with lightsabers. Then flooding Facebook with Star Wars photos, intriguing more people to go Changi and then go watch the movies. This offline and online loop is really the force awakening the new paradigm shift as we move forward. The winners would be companies that could find the balance well between both offline and online, the light and dark side of consumerism.

May the Force be with you! Merry Christmas and Happy Holidays!

Tuesday, November 24, 2015

The Thing About Prediction

A recent book titled Superforecasters is making waves in the financial circle as expected. The book proposed that it is possible to predict the future, if a good team was in place, with teammates coming from very varied backgrounds and good training. Coincidentally, there had been a few occasions on this website where we discussed prediction and its ultimate futility. Today, we try to marry these concepts, hopefully coming away with a few key ideas for readers to ponder about.

I believe the first thing to know about prediction is to never trust any. Never trust anyone who claims that he can predict and never trust any prediction to be accurate. The business of investing is not to predict the future. The business of investing is to try earn a high expected return by thinking hard about what could happen. Using historical standards this translates to 8-10% return per year and one needs to do this over very long time frame while minimizing risks of losing money. 

The future, is inherently unpredictable and until it happens, it remains a set of probabilities. Pundits will forever say they can predict the future, but the truth is no one can. When the future happens, they would dig out what they have said in the past and then say, "See! I was right!". That's amateur. In today's post, we hope to get all readers to see past all these.

Let's illustrate with a few examples. Imagine we have a four sided dice and we roll it. For those who have never seen one, take a look at the picture below: these nicely shaped in pyramids with four possible outcomes are four sided dice used in old board games (at least that was the way I used them).

Four sided dice

There are four sides that give four outcomes. We can think of most futures as such, usually there are a few outcomes, one of them will turn out right. So if someone comes and predict the next role will be 4 or 2 (in the dice, it is the number at the bottom) and he turns out to be right, how much credit should he get? The whole world of finance and investing is essentially full of people guessing the next roll, then claiming they knew, they can read the future. Obviously it's not possible. It is only claiming glory in a game of chance after the fact. That's what we meant by "amateur". That's the first point we need to understand. The future is a set of probabilities.

Let's move on to another analogy: now it's four horse race. So now the probability is changing, in the previous dice, all the outcomes have the same 25% probability of occurring. In a horse race, there are champions, and dark horses. Say Horse 1 (Jedi Star) is the favourite, the chances of winning is 50%. Then Horse 2 (War Horse) and 3 (Force Horse) has 20% each and there is the Dark Horse (Dark Side), with only 10% chance of winning. Horse analysts spent careers analysing horses, trying to make predictions. Yes there is some skill involved, but still, luck is pretty dominant. Pundits in the financial world would, by and large, be more like these horse analysts. The skill element while present is elusive. This is very well discussed in a recent book by Michael Mauboussin called The Success Equation.

In some games, skill is very dominant, like baseball or tennis. But in others, skill and luck becomes equally powerful. It is possible for some horse analyst to be able to predict race results or for analysts to predict economic outcome? Yes, there are gurus out there can get some predictions quite right. How right? Well, about 60% of the time. There is still a lot of luck involved. This is the reality. The gurus out there get 6 out of 10 predictions right and 4 out of 10 wrong. Close of half the time, they are wrong. This 60% is the same number that appears over and over again. The best fund managers get 60% of their bets correct. The best basketball players gets 60% of their shots in the basket (or somewhere around the vicinity). Hollywood makes 6 blockbusters and 4 flops.

So, it is not about predicting.

Then what is it about? Well, it is about getting the probabilities right, getting the math of expected return to work, sizing the bet, understanding the reality better, accepting risks and the possible failure ie losing money. It is hardwork, like card counting, or trying your best to make a fun, touching, universally popular movie like the ones Disney Pixar produce. Each movie take years and thousands of man hours. And still, some of them flopped at the box office. In fact, it is very difficult to predict which movie will make it, according to Hollywood insiders.

This is what the game is about. Let's use a real investing example: our favourite shipping liner Neptune Orient Line or NOL in short. It has gone up 50% in the last three months. It was at a 10 year low at 80c and it shot all the way up to $1.2 or so. Some analysts got it right and they say, "See, NOL is worth a lot, now someone is willing to buy at a much higher price vs 80c." Was that foresight?

Let's turn back to clock to say a year ago, i.e. 2014. The shipping industry had boomed and busted primarily because of China. It went from a total shortage of ships to 30-40% over capacity in a span of 6-7 years. At the peak of the capacity shortage, customers all over world scrambled to get shipping lines to send their goods. It cost more than $2,000 to ship a container box (called TEU in the industry) across the globe. Shippers were super bullish, they started building more ships and bigger ships. They argued that the vintage of ships globally were too old. A lot would need to be scrapped. Hence there was a need to increase capacity by a lot.

Then the GFC came, and then China collapsed. These ships, which took 4-5 years to build, came out right at the point where demand was non-existent. Ships had no goods to ship. They decided to go slow steaming i.e. running at half the usual speed, to save fuel and also to reduce capacity. Shipment cost per TEU collapsed.  That was still not enough, they cancelled orders for ships that were built halfway. Then also scrapped all the old ships. Some shippers went bankrupted, even a large one was at risk. But still the over-capacity issue could not be solved.

NOL five year chart

NOL was right in the middle of it all. It was bleeding through the hull and struggling to stay afloat.  It was burning a billion dollars per year for the last few years. Its book value dropped from $1.5 in 2008 to 80c in 2014. They cancelled orders, cut costs to conserve cash and finally sold their logistics business to raise cash. To rub it in, it was rumoured that Temasek decided it would not save NOL after saving it so many times. So this was it. This was the moment of reckoning for our beloved shipping line.

So, what were the future options for NOL? Now we must understand we should not have the benefit of hindsight as we have now. At that point in time, we would need to try to paint the future in a few options. Here's what it might look like:

Option 1: Cut enough to pull through, TEU prices cannot remain below cost forever

Option 2: Raise money from other investors or the market

Option 3: Bankruptcy

Option 4: Find a strategic buyer

There could be more options, but let's put it at four. Next we have to assess the probabilities and also the return potential of each option. Now, since we won't have the luxury of having full time analysts working on these, the no.s would be pretty arbitrary. In a real process, each number would be debated and each return potential calculated and debated and re-calculated. That's real investing and real work. It would take man hours of analysis. Lots of mental workout. Again for simplicity, we would say that the price was 80c while we were doing this. Here's how the future could pan out, at that point in time:

Option 1: 30% probability, book value dropped by another 20%, share price hit 60c (-25% return)

Option 2: 40% probability, equity raised with 30% dilution, share price hit 50c (-37% return)

Option 3: 10% probability, bankruptcy, share price goes to zero (-100% return)

Option 4: 20% probability, strategic buyer buys it over at a slight premium, share price hit $1.2 (50% return)

So, working with these probabilities and return numbers, it would be clear that NOL had very poor expected return. It would be a negative 22% based on the above probabilities. In fact, we could play around with all the probabilities (and/or returns) and realized that most permutations gave poor expected returns except when we ascribed a 60% or higher probability that a strategic buyer buys it over.

So for those analysts who said they got it right, was it foresight? Or luck? Or something else? For the un-initiated, a rumoured bidding war between two strategic buyers came out for NOL which is why the stock is now up 50% from September. This was one of the future options that panned out. But it could well have been bankruptcy or more likely equity raising in the market with Temasek not supporting it. The future was always just a set of probabilities, what turned out to be the reality/future doesn't mean it should be. No one could have read the future.

As it stands now, it is still unclear how far have the negotiations moved. All bets could still be off because it is ultimately not very beneficial to buy over NOL. What could NOL provide that Maersk or CMA couldn't get? It doesn't need more ships nor crew nor customers (they have the same customers). It would just be a case of buying NOL over to shut it down so that there is one less competitor to disrupt prices. Does it make sense? Or would the buyer try to strike a deal with Temasek and Singapore to get preferential treatment at PSA terminals globally? Or what? It was not clear.

Hence it wouldn't be easy to ascribe a high probability that a strategic buyer would bail out the current NOL shareholders. But as it turned out, this is what caused the share to skyrocket. There would be pundits who would want to claim credit. But as astute investors, we should know better.

The thing about prediction is that it is not what we think it should be like following pundits and it is actually a lot of hard work thinking through everything. The term Superforecaster might well be a misnomer. Well, as Singaporeans, we still hope NOL gets saved though. Happy Thanksgiving! Cheers!

Friday, October 23, 2015

Pay Up for High ROIC! (Part 2)

Do read from the first post.

So does it make sense to pay 20x for 20% ROIC? The answer is YES! In fact, as a rule of thumb in Singapore's investment circle, we should pay one multiple point for 1% of ROIC. So if it's 20% ROIC, we can pay up to 20x and still get a good return. If it's 30% ROIC, then it's 30x. Here's the same table from the previous post showing a 15% ROIC business, let's call it Table 2.

Table 2

So as we can see, at Year 8, even if we value the business at just 10x its earnings per share or EPS, it is worth $30.6, which is more than twice the original price of $15 if we paid 15x for this 15% ROIC business. Now eight years might be a tad too long for most people on this planet, particularly finance people working on Wall Street, or for those of us who can't wait for 2 years for a new iPhone and go for the minor upgrade S version and be disappointed but for true blue value investors, this is the time horizon we are talking about. 

To test the rule of thumb, here's another table (below) showing how long it takes before we double our money using the same assumptions in Table 2. As we can see in the Table 3, testing the original rule of thumb of paying one multiple point for 1% of ROIC, it takes 6 to 8 years to double our money. In fact, if a business can generate sustainable ROIC of 50%, even paying 50x PE, it would only take 5 plus years to double our money. 

Table 3

But how do we know that this 50% ROIC is sustainable? Well, we don't. We can only base in on track record of both the business and its managers. As we discussed before, there are inherently good businesses: consumer related brands, razor-and-blade models, asset light and recurring revenue operations but as businesses grow, incremental return would diminish. For those of us who had scoured businesses across the globe for years, well ROIC of 50% doesn't sustain for too long. 

Hence while in theory it works, in reality, even if we see one or two years of 50% ROIC, it should be safe to assume that ROIC would normalize at some point. Alibaba illustrated this point well. It went public with ROIC at 50-100% which allowed its promoters to justify paying 50-100x for this world's #1 internet stock. ROIC then went on to normalize to around 10-20% today and we saw its share price fell from $100 to a low of $50 before rebounding to $72 today.

Alibaba's ROIC from Gurufocus

More importantly, business managers must stay really focused to reinvest all those earnings for us at higher than normal ROIC (normal means only 8-10% ROIC). Most business managers aren't able to do that. They would see all these cash being churned out and be tempted to use them to buy up low ROIC businesses. It's just too hard to sit there and see the cash pile up for most corporate CEOs. This is why it is way more difficult to find strong capital allocators. Especially so in today's world of short-termism. Even if the CEO did resist doing silly investments, he would be bombarded daily by hedge funds and bankers asking him to spend the money. It would take a zen master to be able to resist the Wall Street vortex of financial sorcery.

Hence, based on experience it is really difficult to find businesses with sustainable ROIC of more than 25%. If that is the case, we have to assume that most businesses would only be able to generate at best high teens ROIC over time. Then going by the rule of thumb, we should then be paying just high teens PE. In the past, I have advocated not buying anything at more than 20x PE. This is one of the criteria of an all-important checklist.

So pay up for high ROIC, but only to a limit - 20x!

Friday, October 16, 2015

Pay Up for High ROIC! (Part 1)

Part 2 is out!

In financial math, high ROIC or return on invested capital can justify almost any PE to buy. This is what this post strives to illustrate. Do read on, it's really important! Promise you won't waste your time. Invested capital simply accounts for all the capital that businesses need: equity and debt. ROE which stands for return on equity, does not take into account of debt. In the financial world, most people talk about ROE but essentially both ROIC and ROE are about how much we can get back by putting in $100.

The genesis of this post comes from:

Some businesses are inherently very strong and generates huge cashflows. For every $100 that we put into the business, we could be making $20. That's ROIC of 20%. One example could be the potato chips business. Raw materials are essentially potatoes and packaging materials which cost next to nothing and what matters is the ability to put it into shelves around the world, in the 7-11s, the Tescos and the mom-and-pop stores all across the planet. Well, this, my friends, is the business moat: global distribution networks that takes years, if not decades to build. The world's biggest potato chips maker had shown that ROIC of this business is pretty high. That's Frito Lay or Pepsico, the listed parent entity.

Don't we all love Frito Lay?

For simplicity let's assume that the potato chips firm can generate 20% ROIC (Pepsico does around 15%). We further assume that in Year 1, its earnings per share or EPS is $1. Because of it's ability to return 20%, this $1 will make $0.2 in Year 2 and together with the original ability to make $1, EPS in Year 2 is $1.2. As we can see, this is compounding at work, So Year 3 will be $1.44 and Year 10 EPS is a whopping $6.2. Assuming that we paid $20 for the EPS $1 in Year 1, ie paying up 20x PE, what is our return after 10 years? It's phenomenal! (All this math is in Table 1 below)

The original capital of $20 now generates $6.2 i.e. over 30% return, over the next decade, it will generate more than the original capital in one single year (Year 17 to be exact). If we assume that it trades at 10x PE at Year 10 (which is ridiculously cheap, remember we bought it at 20x PE), the stock will be worth $62 (ie more than double our original purchase price or around 7%pa using our rule of 72. In Year 17, when EPS is $22.2, more than two dollars higher than our purchase price, the same stock should be worth around $222 dollars at 10x PE. So, in a nutshell, what we bought at 20x PE became a ten bagger. Thanks to its ROIC!

Table 1

In Year 20, using the same methodology, the same stock will be worth $383 while generating almost twice the our original capital ($20) in  EPS (of $38) in a single year. This is why we pay up for high ROIC!

Saturday, September 26, 2015

Invert, always invert

This is a quote originally from Carl Jacobi, a German mathematician but has now been attributed to Charlie Munger, Vice-Chairman at Berkshire Hathaway, investing partner alongside Warren Buffett. Munger used this phrase so many times in so many of his books that value investing students would have to come across it sooner or later. 

Inversion is a technique used widely in math to solve problems by reversing the thinking to come to some kind of solution. In investing, Charlie encourages us to also always invert to see through issues that are not easy to do so conventionally. Today, we would like to discuss three topics about inversion and hopefully gain some insights about using this technique in the future.

Satoru Iwata, the late President of Nintendo was perhaps one of the most brilliant executor of inversion. Sadly he passed away this year before being able to steer Nintendo to greater heights after its successful launch of Wii some ten years ago. Not sure if most readers would remember, during 2004-2006 the gaming market was an epic battle of specs between Playstation and Xbox. Back then there was no mobile gaming, PC gaming was very niche and game consoles were the main devices that people played games with. Sega was dead after it lost out to Playstation and everyone thought that Nintendo would follow Sega.

Sony and Microsoft were well funded to develop game consoles that were going for higher quality graphics, faster controllers, more storage, customized computer chips to run these machines. Nintendo had neither the cash nor the resources to compete. Hence Mr Iwata decided to invert the problem. The problem was not about what core gamer wants, which was thought to be all of the above: graphics, speed, specs and all. The problem was how to get the non-gamers to play games.

Nintendo and all its cute characters!

The answer was the Wii. It had none of the graphics, nor speed, nor specs. It was cutesy Nintendo characters and the innovative wand controllers. It was about making game play much more accessible to non-gamers and it worked! Wii sold more than 100m units and Nintendo at its peak became the 3rd most valuable company in Japan. However the Wii also opened the market for casual mobile gaming as people caught on to how games should be made simple, addictive, fun and on the mobile phone which was in everyone's pocket all the time. Nintendo did not catch this mobile gaming trend fast enough and went into losses. But Iwata-san was quick to react and switched the firm to join the mobile bandwagon last year. Again by inverting the logic that Mario games should only be played on Nintendo devices.

Iwata-san did not live to see the fruits of his legacy as he succumbed to cancer that plagued him for two years. He worked till the final days of his life, giving all he had for the firm, for the shareholders and for Nintendo fans. Iwata-san has my full respect as an innovator who dared to invert mainstream logic and brought the firm to a soaring success never reached before and will likely be renewed with the direction that he set by moving into mobile gaming. Rest in peace, Iwata-san!

The second and third topic would be around TED videos that I watched recently that really opened my mind to issues that are really important. Do read on carefully! Before watching, I was pretty much thinking the same way as most people would, but the videos showed that by inverting, we get to enlightening solutions. The first one is on charity and the second one on happiness and work.

On charity, the consensus thinking, which was also my thinking is that charitable organizations should never aspire to pay its staff market compensation. They should also work with a low cost to donation ratio (like 10-20%) and spend very little on growth. But the speaker argued that all these were wrong and if we continue to think the way we did, we would never solve any of the world's biggest issues like poverty, cure for diseases or helping the disabled and the less advantaged.

The speaker gave powerful examples to illustrate these points. Most memorable being that a CEO of a charitable organization could only be expected to receive $80,000 a year while a CEO of say even a small SME would be paid $200,000 and an MBA graduate would be paid much more than that as they reach the peak of their careers. So these folks could donate half their income, seat on boards of charitable organizations to supervise the poor CEO and be recognized for doing good charity, enjoying fame, status on top of being rich. So who in the right mind, with the capabilities of a SME CEO or earning an MBA would want to be that CEO of a charitable organization and really do all that heavy duty stuff and yet get supervised by MBA grads?

Well, for those really interested, I strongly encourage you to watch the video:

The solution was really to invert and think big. For charity to really become a force to reckon with and solve the world's biggest problems, they have to be for profit corporations, not non-profit charitable organizations. This is inversion at its best!

The last issue that was interesting was related to happiness. The conventional thinking was that we think of happiness as a goal, as something to be achieved, as boxes that needed to be ticked. If we do this, we will be happy. If we go for that holiday, we would be happy. If we achieve that sales target, we would be happy. But the speaker opined that the inverse was what actually made much better sense. If we were happy, we would do this, and do it better. If we were happy, we can plan and enjoy that holiday much, much more. If we were happy, we would over-exceed the sales target by manifolds. Invert, always invert!

The key to happiness is not about goals and ticking boxes. It's to train our brains with the few simple things below:

1. Write down notes of gratitude for one thing and one person daily
2. Share a moment with our loved ones
3. Perform a random act of kindness
4. Exercise or engage in some physical activity: gardening or photography
5. Meditate or contemplate our day and update them in a journal

The talk below:

Time to invert and transform our lives!

Thursday, September 10, 2015

Cooling Off Day Post

While the global stock markets rocked in choppy waves of unprecedented volatility in the last two weeks, Singaporean investors were probably busy following the campaigns of the current elections. This round to me seemed less interesting vs the previous cycles where we saw various tumultuous sagas involving CCTVs, sweet young things vs sweet young things, Dr Chee shouting at PM Goh like a gangster, Cheng San GRC (for those of us old enough to remember). This round we pretty much got to get excited only about this Titanic poster below.

For the un-initiated, this was an argument using the analogy of cruise ships. PM Goh liken PAP as a solid cruise ship with a final destination while WP is a gambling cruise ship sailing to nowhere. To which Mr Low replied that perhaps the more apt example would be comparing Singapore to Titanic, which sank. PM Goh then replied Singapore had  been sailing for 50 years, while Titanic sank on its maiden voyage. Creative Singaporeans then created the poster. Who says we cannot innovate?

The Father of Value Investing, Benjamin Graham left this quote some 70-80 years ago: "The stock market is a voting machine in the short run but a weighing machine in the long run." Some things just don't change. We tend to vote with our hearts, not our minds. Hence we keep seeing actors, boxers, prominent people getting voted into government all over the world: Ronald Reagan, Manny Pacquiao, Arnold Schwarzenegger just to name a few. But what is really important in both elections and stock picking is really to see through the rhetorics and power acts to the essence and make rational choices. 

In investing, that's about understanding and then selecting really strong businesses and buying them at the right prices. It's an art that would take a lifetime to master. Yours truly is still working on it after 10 years. In tomorrow's polling, it's another kind of selection, akin to giving a Facebook "Like", obviously, much more important and with serious consequences. So give it a good hard analysis as we would when we analyze and look at stocks.

A weighing machine will not lie. It tells you where you were before and where you are now. Humans take about 20 years to grow from 2-4 kg at birth to an optimal 40-80kg. Well, a lot of us continue to grow laterally, exponentially, massively after that but that's another topic. :) Both gaining and losing weight significantly are not easy manoeuvres. Changes will take time to be reflected. Hence the analogy that the stock market is a weighing machine. Over the long run, great companies see their stock prices follow exponential curves, mediocre ones fall flat or slope downwards. Nations follow the same paths. 

Singapore's GDP growth follows an exponential curve

Singapore grew spectacularly in the last 50 years. It will be quite unlikely to repeat the same growth in the next 50 years. Nor do Singaporeans want that at the expense of lower quality of life. A lot of election topics revolved around the price we paid for our spectacular growth: foreign workers, MRT breakdowns, rising cost of living etc. But we do need to keep improving. Growth is the only way forward. It may not be economic GDP growth at 8% but we do need some form of growth: entrepreneurial or perhaps cultural or at the individual level (ie you and me) spiritual growth. 

Our decisions tomorrow would decide the growth trajectory over the next five years. Will it be giving up some GDP growth for better quality of life, or continuing GDP growth at all costs or poorer growth in all aspects? It will be our choices!

Sing First Sing First Sing Sing First!