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! 

Thursday, August 27, 2015

This is just the beginning...

Market participants rode through one of the scariest financial roller-coasters in the past two weeks. In Singapore some stocks were down 7-8% in a single day, cumulatively losing 15-20% in one week. In the US, things were even more dramatic, some stocks when through 20% intra-day swings. Then today everything bounced, as if nothing happened. It was really quite unsettling. Most of us would be asking, "Why? Why? What happened? What now?". Sadly, at this juncture, there are no good answers. That was what happened during the first two weeks for the Lehman crisis.

Markets are a bit like earthquakes. Shifts in tectonic movements cause tension to build up and over time this would result in earthquakes or eruptions, usually once every 10 to 20 years, we see a mega earthquake around the same vicinity. There was Kobe in 1995, then Fukushima in 2011. In the financial markets, we see the same phenomenon. Tension builds up over time as investors feel comfortable and buy up everything, at high valuations until some catalysts trigger a major sell off.

It was said that the Global Financial Crisis (GFC) would be a trilogy. We saw the original crisis created when Lehman collapsed, which then shifted to Europe with the Greek saga and now coming to Asia with China. This pattern resulted because of the measures brought in to stabilize the system. When the GFC first occurred, Europe unleashed its liquidity to save the banks, the Greeks took advantage of that and over leveraged and its tragedy unfolded. Then China dumped 4 trillion RMB to save its economy and led to over-capacity in every form: ghost towns, roads to nowhere, idling steel plants, you name it. 

Now all the death stars are aligned, we just saw a crazy stock market boom in China from late 2014 to June 2015, US stocks were at all-time high valuations after months of rally and Europe started to feel euphoric again. Things are really ripe for a collapse. As usual, nobody saw this coming. Because the future is unpredictable. We simply cannot tell. But based on past experiences, we can guess what is more likely to happen. The guess today is this is just the beginning of a more major collapse.

Why so? The following chart might give us some clues. 

STI's Price, PE and Dividend Yield

The above is a chart of the STI from 2005. The price movement is in white and brown bars give the PE over the years and the purple bars show the dividend yield. So, it is now clear that even with the heart wrenching crash last week, STI's PE is still high at 12.5x compared to its own history and dividend is not at all attractive at 3.5%. Even when compared to the Greek crisis in 2011, when PE was 10x and dividend rose to 4.5% we cannot say we are close to that kind of level. 

Hence it is more likely that as the global markets continue to cough and sneeze, STI will see more bloodshed. We could be heading below 2,500 before there is any stabilization. I really don't think STI would revisit Lehman lows of 1,500 and dividend going to 7% given that the global economy is not at the brink of collapse as it was during Lehman. 

Those were crazy days, it was said that the world as we knew it would stop functioning. Fiat currencies would mean nothing and all the zeros in our bank accounts would literally mean zeros. Imagine life savings gone! Those with land or livestocks could be king because they could grow their own food or live off their animals. This is not a joke, take a moment to think about how the world could have changed.

Well, that didn't happen. But you can read about it in, "What Could Have Happened".

Now we see the alternative scenario playing out, the crisis had become a trilogy and this final installment is in front of us now. It is not a bad thing for the market to fall another 20-30%. It would be a great opportunity to buy those really great franchises we talked about and also to reconfigure our portfolios to better names. This is a rare chance in almost a decade. 

Again, this is not a prediction. All we are saying is that there is a high probability that the markets will have to fall another 20-30% before things are sorted out. But it could also well be that markets again shrug off the woes because the world central bankers decide to do another round of global QE (rather than raising interest rates in September as was talked about), and we see the tides rise again! That's low probability but to zero probability.

So buckle your seat belts, the ride is about to begin!

Wednesday, August 12, 2015

All-in costs, breakeven costs, cash costs

Analysts of deep cyclicals, industrials, commodities would be very familiar with these terms. These terms are invented by the financial industry to try to help analysts analyze real businesses from their desktops, in plush offices, hundreds or thousands of miles away from where the businesses actually took place. It bears little resemblance of how real ops managers actually thought about their costs or how businesses actually operated. 

All-in costs refer to all the costs that are needed to start and ramp up a business. Take the example of a gold mine, the all-in cost today for digging up an ounce of gold is supposedly $1,000. Today gold trades at $1,100 per ounce. So if gold falls below $1,000, then new gold production should stop since no one would spend $1,100 to dig something and then sell it for $1,000 right?

But wait, all in costs involved sunk cost like exploration, consulting fees, shared costs like HR, R&D and needless to say, actual operation costs like building the mine facilities, transportation etc. Maybe we shouldn't include some of these. What's important is the breakeven costs. This takes out the sunk and shared costs. Breakeven cost is the true operational expenses including depreciation, utilities, transportation etc. So maybe the true bottom for gold prices should be $600-800 per ounce, which is the estimated breakeven cost range.

Ok that made sense, which is why gold has not even come close to those levels in the last few years. But in another familiar highly cyclical industry close to home, we saw how prices crashed below breakeven costs: shipping. Shipping is a notoriously tough sector. Long time value investors would know to avoid these capital destructive firms. Let's take a look at the breakeven cost again.

While most of us would be familiar with container shipping, which is the bread and butter of our beloved national shipping company: Neptune Orient Lines or NOL, looking at the bulk Capesize shippers for shipping bulk commodities would serve to illustrate today's point better. There are 1,000+ Capesize ships globally shipping bulk commodities like iron ore and coal all over the world and the shipping rates of all these ships are calculated into an index called the Baltic Dry Index or BDI. The chart below from the Economist shows how the index traded over the last 10 years.

The infamous BDI index

During the heydays of 2006-08 the BDI traded at 10,000 levels, 2 digits higher than today's paltry 500. Back then it was impossible to fathom that BDI would fall to today's level. It is yet another manifestation how our primitive homo sapien minds worked (we really cannot think long term) and how unpredictable  the future really is. Just as it is today, can we imagine BDI would again go to 10,000 say 8 years from now?  

It is said that the breakeven cost to run a Capesize ship is about $30,000 per day. This breakeven cost would include depreciation of the ship (a huge part of the cost), the fuel, the crew and other miscellaneous including docking fees etc. This $30,000 per day translates to roughly 3,000 on the BDI and it does form a strong support over the last 10 years. Notice the support in 2005-06 and again the resistance/support in 2009-2010.

But in late 2010, the BDI broke the 3,000 low and fell all the way to 1,000. Nobody could figure out how could this happen. No business should operate below its breakeven cost. It means that for every single day the ship was out there, it was losing money. This is negative margin. It should not happen but it did! So analysts came up with another explanation: cash cost.

Cash cost refers to the cost that is needed to operate a business, on cash basis. This is serious. Breakeven cost has non-cash components like depreciation but cash cost means pure cash in and out. No business should operate below cash cost. So, back with the Capesize ships, the cash cost is estimated to be $15,000 per day, this is the money needed to pay the crew, to pay for fuel, all cash involved. So this should be the absolute bottom for spot prices. If prices fell below this, then all the ships should stop running. No company will burn cash to operate any business.

Then in 2015, the BDI broke 1,000. It fell to 500 and remained around there, a 30 year low. 500 on the BDI translated to just $5,000 per day. So theoretically, we can book a Capesize ship for $5,000 a day for some event, like a birthday party or a wedding! It's cheaper to host a wedding banquet on the ship vs in a Singapore hotel. For all that analysis, BDI broke the cash cost level and remained there.

What happened? 

Why did shippers operate below cash cost? Didn't they know that they are burning money every day? Yup they did, but that was not part of the equation the real business operators were working with. All-in costs, breakeven costs and cash costs exist only on spreadsheets. In the real business, Capesize ships have to run every day, it would take a few weeks just to reach anywhere and a few months to fully stop operations. Even worse, these ships were funded with credit. They could not be stopped even if revenue fell below whatever costs.

Stopping ships from running might trigger default and meant paying back the banks whatever loans that was used to finance buying the ships in the first place. So shipping co.s had to operate as long as revenue was not zero. ie as long as the BDI was not zero. Also there was always the hope element. Managers would always be hoping that things would turn. If they bled for just three months, maybe enough ships would be off the market and prices would turn up again. But since everyone thought the same, that didn't happen and BDI remained at 500. That was the reality. 

This is the same story for many, many cyclical industries. We saw that with semiconductors, with commodity prices and even crude oil. There was not such thing as breakeven cost level or cash cost level. The only true real level is zero and market forces determine when the rebound would be. In the end, the message is this: stay away from commodity businesses where companies do not have pricing power but take prices from spot markets. Buy strong businesses with great global franchises. These are the best bets that we could compound our money at above average growth rate over time.

Thursday, July 16, 2015

Grexit? THIS IS SPARTA!!!!

Five years and 3 bailouts later, it's amazing that the leaders in Europe haven't made any progress in this long and painful odyssey of pulling Greece out from hell. Everyone had their fair share of blame. The latest instalment this year from May-Jul 2015 started with Alexis Tsipras, the Greek PM who thought that he was King Leonidas, went to the negotiating table with the European Union  (EU) demanding money and yet promising no reforms. Essentially reminiscing the unforgettable scene from the comic based comical epic movie: 300, released in 2006. 

This is Sparta!

For the un-initiated, the scene was about how a Messenger from Persia came to negotiate with King Leonidas of Sparta, that if he was willing to be subjected to the rule of Persia and the god-king Xerxes, his country will be spared from bloodshed. King Leonidas refused to kowtow and bellowed the famous words, "THIS IS SPARTA!" and pushed the Messenger into a bottomless pit.

In the Greek tragedy unfolding today, we also see Tsipras shouting in a similar tone to his counterparts in EU. Essentially demanding respect and refusing to kowtow to the whims and fancies of the likes of modern-day aggressors. Sadly, Greece today is not Sparta. Greeks today have zero will to train hard to climb out of the bottomless pit of debt but chose instead to rely on its ridiculously generous government pension system to live on borrowed money indefinitely.

To give a flavour of the system's atrocities, Greek pensioners get to retire at 50, draw a monthly pension of roughly 2,000 Euros (c.S$3,500) per person per month for as long as they live. That's part of the reason why employment rate is 25%. Unsurprisingly, close to 3m Greeks out of a population of 11m lives on pension and the Greeks spend a whopping 20% of its GDP on pension. This is the highest ratio even the EU and perhaps even globally. Singapore spends like $20 on pension?

No wonder the rest of EU is upset that Tsipras has the cheek to come back and ask for more money while achieving nothing. And when he didn't get what he wanted, he started playing games with EU ultimately culminating to the scary referendum in his country. That was the same trick that his predecessor played. He was probably thinking if the Greek voted YES, then he could give in to Europe and be hailed as hero for keeping Greece in the Eurozone. If they voted NO, he would use that as a bargaining chip to maintain Greece's crazy pension on top of asking for the scale back of other tough austerity conditions imposed by the EU during previous bailouts.

Well, that didn't work. EU caught his bluff. Now, the Greeks voted NO, but the reforms just got harsher! Bcos Greece met it's match - Artemisia, in the form of Germany's female chancellor Merkel. This lady is ruthless. She humiliated Tsipras and Greece by forcing harsher conditions including securitizing Greek national assets, possibly including the kingdom of Sparta and the infamous bottomless pit at its townhall, in a $50bn fund for future payment in the event that Greece did not reform. This is akin to Singapore selling our Merlion to pay debts for 1MDB (oh yah, should be Petronas Towers). It was too much. Merkel became Europe's enemy overnight.

Artemisia, well... protrayed here not by Merkel but Eva

But the financial markets were just relieved that Grexit did not happen and the party continues, oblivious that this was just kicking the can down the road for another 2-3 years even if it passes through all the respective parliaments in the next few days (Greek passed theirs). The ordeal continues, Odysseus has yet to meet the Sirens. So we are now left hanging at the cliffhanger moment. Again. 

Can Greece muster enough will to reform after failing twice in five years? The odds are definitely against them. It's like giving a drug addict three years worth of drugs after which he must promise to quit. Will he really quit after three years? Yeah... right... So far, Greece had failed to live up to that promise. Despite all other alphabets of the original PIGS actually doing it (Portugal, Ireland and Spain). Grexit might really be the Hobson's option. In fact, Merkel and Tsipras fought it out last weekend (or as we would prefer Leonidas and Artemisia) and it nearly didn't come to this. The world would be very different today if Grexit was the conclusion last Monday.

Well, we might have that in 2018 and hopefully by then perhaps Europe would be ready for that. Sort out the laws for Grexit, get ready the printing machines for the new Drachma, humanitarian aids and supplies ready to help as the country implodes. It would be a sad day. A micro Great Depression just for the 11m Greeks. It would then really take Spartan philosophy to get the country back into shape. 


Monday, June 29, 2015

Checklist for buying stocks - IMPORTANT!

Just finished reading "Education of a Value Investor" by Guy Spier. A short and informative narrative by a value investor about his own journey. I found it really useful and would like to incorporate a few key lessons from what I have read. We all know the importance of checklists, pilots and surgeons use them, so should investors. Charlie Munger had said it years ago that all prudent investors should have one and Guy got the idea from Charlie.

Guy went one step further by saying that the checklist should be used as a final step to just make sure that we don't get screwed by our brains telling us all sorts of stuff. You see, our brains have this ability to rationalize everything and convince ourselves to do all the things that we desire and not to do the things that we do not want to do. Like when we are due for our weekly jog this afternoon, the brain will start telling us, "It's too hot, there's haze coming, or oh just take a break this week, you worked too hard... etc". So similarly, when we are all excited to buy a stock, the brain will overlook all the impt warning signs and say, "Yeah, it's a great buy, don't worry about the balance sheet, or the parent company will buy it out if it falls, or the competitors are too weak to matter... etc". Don't fall for all that Jedi mind tricks that we play to ourselves. Use a checklist. Here's mine in no particular order. It's still a work in progress but I guess it's important to start somewhere.

1. Look at the balance sheet and Net Debt to EBITDA or cashflow, does it look prudent enough? Usually Net Debt to EBITDA should not be more than 4x.

2. Does it have sustainable ROE over the last few years? Should be a double digit number or at least high single digit if it has a lot of cash on its balance sheet.

3. What is the track record of its management. How much did they pay themselves? Did they screw minority shareholders?

4. What is the nature of the business, is it a cut-throat dog-eat-dog business? What is their moat? How many players in the industry? What is the combined share of the largest players?

5. How many times have the company raised capital?

6. Who are the other shareholders? Are there a lot of insiders?

7. Free cashflow (FCF) track record: does it have a consistent and even better, rising FCF over time?

8. Finally valuations, valuations, valuations. Is it below PE of 20x and EV/EBITDA of 14x. How about it's free cashflow yield. Can it return 3x over 10 years?

As mentioned, this is a starting list and although it could work for me, your checklist should be different. It's more as a reference to be shared here and over time we should keep revising our checklists. 

In the book, the author also mentioned that we are all slaves to our unique brain wirings and it is very difficult to overcome some of these innate idiosyncrasies. So we need to change our physical and social environment to help us. For him, he moved from New York to Zurich to get away from what he called the "Wall Street Vortex" that sucked him into lots of unhealthy behaviours like following too closely to short-term newsflow and comparing egos with the who's who in Big Apple. Also, for our social environment, it is well-known that people who are overweight have more friends who are overweight as well. Sadly, it's the environment that would change us, not the other way round. 

We need to tip everything to our favour which means we need to change our physical environment to ensure that it is compatible with our wirings. This would be making our home and work environment really conducive. I think for me one simple and yet important aspect is really just to reduce clutter. Keep our workplace simple and effective, stop buying unnecessary stuff and work with minimal tools and gadgets. Reducing clutter is the real boost to efficiency.

We also need to improve our social environment. Stop wasting time with people who don't value add. We have to keep the best friends that have given us the best advice over time, friends who are willing to share, non-pretentious, people whom we are 100% comfortable hanging out with. This could be the single most important change we make at the current stage of our lives. It takes years to build good and strong relationships and the window is closing for those of us reaching the midway in life. Once we surround ourselves with the best people we cannot help but improve! 

To conclude, I would like to share this old adage that comes to mind, "Make new friends but keep the old, one is silver but the other is gold." Make sure we have a lot more of these friends with the highest caliber!

Thursday, June 25, 2015

Jardine C&C Rights Issue!

Jardine Cycle and Carriage (JCNC) announced a surprised SGD billion dollar rights issue a week ago. Well given how the stock has declined a month before, I guess it wasn't a surprise to some insiders. Now that the cat is out of the bag, it's time to do a quick and dirty analysis on this blue blue chip. 

For the un-initiated, JCNC is probably most well-known in Singapore as the distributor for Mercedes-Benz and making tons of money on that franchise but in reality, the Singapore business contributes at most 10% to profits and the bulk of the business actually comes from Indonesia. JCNC's subsidiary Astra is the largest automobile and motorcycle distributor in the ASEAN's largest country and earning very, very good profits. Astra itself is also a conglomerate and owns a bunch of other businesses including plantations and construction machinery (as a distributor for Komatsu). So well, Cycle and Carriage is but a small piece of the puzzle.

Jardine Cycle and Carriage is itself c.75% owned by its parent which is locked in a cross shareholding structure to ensure that they would never be taken over. Jardine Strategic (JS) owns the chunk in JCNC and its counterpart Jardine Matheson (JM) owns Strategic and other stuff while JS also owns JM. Yes... mega-convolution. The Jardine group has a long and convoluted history which we shall discuss in a minute. In a nutshell, it is a conglomerate owning another conglomerate while owned by another conglomerate.

Why so complicated? Well, that's because Jardine is a dynasty and as we know from Chinese drama series about the imperial dynasties, things are more than complicated when we have huge families, multiple wives and concubines. It's already complicated with just one wife... so tell me what happens when there are five ;) ? Besides that, Jardine was actually active during the Qing Dynasty, most infamous for their role as opium traders. This fact alone, causes much controversy to this day which is perhaps attributed to why the families have kept themselves very private and the listed companies are also more than secretive despite their status as public companies.

Nevertheless, Jardine companies have been known as good companies with competent business managers and so investors had turned a blind eye to its lack of disclosure and secrecy over the years. Jardine Cycle and Carriage has generated tremendous value to shareholders in the last five to ten year, thanks to the wonderful business franchise it has in Indonesia.

Jardine's compounding capability

Jardine's business in Indonesia is run by its subsidiary Astra. This is one of the strongest franchise in this part of the world and has helped Astra grow strongly so much so that it is now usually regarded as a proxy for Indonesia. So when global investors are positive about Indon, rather than buying some Indon ETF, they would actually buy Astra. 

Now what's so great about Astra's business? Well, essentially it is the de-facto vehicle distributor in the country with c.50% market share in both cars and motorcycles. It markets for Toyota and Honda and dominates the market. Even better, it also does the financing when consumers buy their vehicles and it also operates the service and maintenance for the vehicles it sells. These are high margin businesses with strong cashflow generation. With this core business it has since branched into insurance, manufacturing, construction, property amongst others although auto distribution remains very important. From its subsidiaries, JCNC has been able to deliver USD 1bn in free cashflow (FCF) annually in recent years.

Finally, let's discuss its rights issue. Why did this great firm, doing great, come to ask for money out the blue? The official reasons were that its debt level of c.USD 4 billion was too high and given that it also spent close to another billion to buy a stake in Siam City Cement, it wanted to beef up its balance sheet. Also given that the parent owns 75% of the firm and has essentially underwritten the whole deal, it stands to benefit from any other shareholders not subscribing and further increase its stake.

The rights would be issued at $26, a 26% discount to its current price so it would be imperative for any existing shareholders to subscribe (esp with the Great Singapore Sale coming to an end, 26% discount is BIG DEAL!). The question is then should new investors buy at this juncture? Well... given that it has fallen quite a bit and FCF actually hits 10% now and if we buy, we get more rights at $26, it seemed like a no brainer to buy now. 

On this note, I would also like to highlight 10% FCF yield is quite a nice rule of thumb to make good money. This is provided that the FCF is sustainable and needless to say the company is a going concern with solid management and a good business franchise. There are usually "10% FCF yield stocks" that screens can throw out but if they are not sustainable then it's meaningless. Once in a rare while you see a great franchise giving 10% FCF. Today it looks like it's JCNC.

Now why is 10% so special? Essentially it means that the co. need not grow, it can just stay status quo for 10 years and we are still good. Say if you give me $100 today and I will give you $10 a year indefinitely. At any time, you can also sell it to someone else and get back your principal of $100. That's a pretty good deal isn't it? Over the course of my investing career, I have found that when a reasonably okay company reaches 10% FCF, usually there's easy money to be made.

What about risks? Of course there are risks, every investment has risks and the call is whether the risk reward is asymmetrical. The first risk for Jardine is obviously the investment that it is making. Siam City Cement is a brand new business in Thailand where the group has not much of track record. It remains unclear why they made the investment. Also as a conglomerate simply owning stakes, its cashflow is limited to the dividends that its subsidiaries pay. Hence the need for capital raising from time to time. The stock has also suffered as a result of the woes of Indonesia and the rupiah weakness but I believe this one is pretty well-known and should be factored in today's stock price.

But having said all that, at 10% FCF yield, JCNC is very palatable and is likely to continue to grow out of these short term issues over 5 to 10 years. Taking a short term view now means only seeing the doom and gloom but in a decade, this would probably look like one of the rare times to be able to buy this strong franchise cheap! 

Saturday, May 30, 2015

China A shares: Mistake turned Multi-Bagger

A long time ago, in blog posts far away, we discussed the merits and demerits of ETFs. It was around the earlier posts that time (2009 and 2010) that I bought into the China A share ETF thinking that buying into the country that would conquer the 21st Century made sense. As it turned out, it didn't. The only ETF that one should buy is the S&P 500. ETFs, by and large, did not help investors make money. Investing is just such a game. What looked so right doesn't turn out right after all.

Buying China seemed so right!

Today's story is about how a mistake turned out into a multi-bagger and what are the lessons that we could learn. I must say, this is first and foremost a mistake. It was luck that turned it into a multi-bagger. The whole process was painful despite making money and if I were able to re-make some decisions, I would do things differently. Now, looking back, there were good lessons learnt. It's really through mistakes that we learnt most. So sometimes, we really should thank bad happenings and results and also our adversaries for showing us our weaknesses. To sum it up nicely, I think the three lessons would be:

1. Understand the downside well
2. Long term holding power
3. Move in incremental steps wisely

At the time of buying China A shares around 2009-2010, it was supposedly a high confidence bet. The Global Financial Crisis hit all markets bad, China was down 50-60% from its peak, it was really looking cheap. The investment thesis was that China would continue to grow to become the world's largest economy in time, surpassing the US. It was hard to pick Chinese stocks well, so why not just buy the whole Chinese market. China A shares was trading at low teens PE, really not expensive. Although financials dominated the index but that was normal for most emerging markets so things should be ok. 

What was the downside? Well it was the implosion of all these Chinese banks that made up half of the index. So if these halved, maybe maximum impact to the ETF could be 20-25%? And if that happened, maybe it was time to add more! As it turned out, the banks didn't implode but the whole market just continue to languish. It went from low teens to single digit PE, earnings didn't improve, so the ETF did go down 20-25% and this blogger added more not understanding it was a mistake. There's a term for this, and it's well depicted in the following pic. Haha.

It's called catching a falling knife...

Fortunately, that assumption of maximum downside for China's A shares didn't turn out to be too wrong, the market just did nothing for many, many years which was bad enough as it meant 0% return. But to try to gauge the downside is always important. In good companies with some business moats, usually the downside could be 20-30%. If that happens, the right decision is to buy more. In some cases, the downside is 50%, then one would need to know what is the blue sky scenario, ie what's the maximum upside so as to justify risking losing 50% of capital. In others, the downside could be 100%, losing everything. This is like buying co.s or small firms with no moat. There is no recovery no matter how long term we are. 

This brings us to the second saving grace which was having long term holding power. So while the A shares did nothing for many years, I wasn't compelled to sell. It was locking up some capital which could have been put to better use but by keeping it to a certain percentage of the portfolio, it was also bearable. What would have been unbearable would be using leverage or making it too big a bet. These are the technical aspects that could have easily changed everything. So always use cash and size our bets wisely. More on this later.

After waiting for half a decade, things suddenly changed in a few months. The catalyst was the Hong Kong Shanghai stock connect. Investors suddenly realized that A shares were "too cheap". If they were connected via Hong Kong, there would be lots of demand for these from global investors. So the whole market started rallying. Meanwhile, domestic Chinese investors saw the wave coming and they didn't want to miss out! Aunties, students, retirees, workers, dogs, cats and their offsprings all started opening brokerage accounts to buy stocks. A shares went from 2,000 points to 5,000 points! For me, it was a mistake turning into a multi-bagger! Woo-hoo!

Snapshot of the ETF's factsheet in May 2015

Lady luck smiled at me more than anything else. It wasn't skill or patience. Although if we calculate the return over 5 years, it would be just 5-9%pa or so. No big deal. I am just glad I got bailed out. I sold the bulk of my ETF while leaving some to participate if there's any more craziness. This is #3: move in incremental steps wisely. Remember that the markets and the future is not predictable. So rather than moving in big steps, thinking that what we decided will pan out as we expect, it is always advisable to move incrementally. Have more than two bullets for each target, we are shooting targets we don't know which way they will move! 

For almost every purchase, it is always prudent to start buying just 1/3 of a full position. If it falls, that we could add. If it runs, then it's just too bad but at least we have 1/3. It is also advisable to phase our buys over time periods like every 6 or 12 months. Market are unpredictable, so never think that we are so damn correct and will be proven right and never put our eggs into one basket. This works for selling as well.

So for the A shares, when it started moving and I was up 50%, I sold 1/3. It then went on to move up another 20% or so and I sold another 1/3. After selling the second tranche, I was left with almost pure profits so A shares could fall to zero, I would still have made money and if it continues to go crazy, I could still participate in further upside. Moving incrementally is one of the most important moves in investing but rarely discussed.

Of course, it doesn't help to cut it too finely or double down unto mistakes. Again, this is an art and it is really hard to come up with specific rules that could work universally. This A share saga was a rare case of a mistake making money. In general, we would be counting on mistakes to help us refine our investment process while hopefully not paying up too much tuition fees to learn basic lessons like understanding the downside well, taking the long term approach and moving incrementally.

A happy Vesak Day long weekend to all Buddhists out there!