Sasseur REIT has been one of the top-performing REITs so far this year. Here is my thought process behind my decision to invest in it in March this year.
Sasseur REIT has been one of the top-performing Singapore-listed REITs this year, with a year-to-date return of more than 40%.
I invested in Sasseur REIT in March this year at a purchase price of 72 cents per share. Today, the stock trades at around 88 cents. In addition to the capital gain, I have also collected 4.9 Singapore cents in dividend (technically called a distribution but let’s not get nit-picky).
In this article, I will explain my investment thesis for Sasseur REIT and whether I think it is still worth a look at today.
Company description
Sasseur REIT owns four outlet malls in China. The REIT is sponsored by Sasseur Group, a privately-owned outlet mall operator that currently manages and operates nine outlet malls.
The China-based REIT was listed in Singapore on 28 March 2018. Since listing, Sasseur REIT has performed well above expectations. It beat its initial public offering forecast for seven consecutive quarters, both in terms of rental income and distribution to unitholders.
My 5-point framework
Over the years, I have built a five-point framework for investing in REITs. I try to invest in REITs that tick as many of the boxes as possible.
As a quick summary, the REITs I invest in should have (1) a good existing portfolio, (2) capable and honest management, (3) a safe capital structure, (4) a fair and responsible sponsor and (5) a decent valuation.
I will describe my investment thesis for Sasseur REIT using this REIT framework.
1. A good existing portfolio
In my view, Sasseur REIT has an excellent existing portfolio.
To understand the REIT’s portfolio better, we need to appreciate its unique mode of managing the four malls it owns. The REIT effectively outsources the management of the mall to a third party called the entrusted manager.
Favourable entrusted manager agreement
The entrusted manager is responsible for maximising the rental income of the assets. It collects the rent and pays Sasseur REIT an entrusted manager agreement rental income.
This comprises a fixed and a variable component.
There are a few things to like about this arrangement. First, the fixed component ensures a baseline level of rental income that is more or less guaranteed every year. The fixed component will also rise each year.
Second, the variable component gives Sasseur REIT the opportunity to participate in the upside, should tenant sales rise.
Increasing tenant sales
There are a few reasons to believe that tenant sales will increase in the long run. For one, total VIP members (a membership program to reward high-spending customers) have jumped a staggering 70% from the end of 2018 to 30 September 2019. Second, two of the REIT’s malls are still relatively new and should attract more shoppers as they mature.
There are also macro-economic tailwinds. China’s GDP is expected to grow by more than 6% in 2019 and 2020. The GDP growth, in turn, is expected to fuel a rise in the middle-income population in China, which will drive demand for discounted branded goods.
Sasseur REIT’s four malls demonstrated impressive growth in 2019. In total, the four malls generated a 20.9% growth in tenant sales in the first three quarters of 2019.
Positive portfolio characteristics
The occupancy rate at Sasseur REIT’s malls is also very high, averaging at 95.4%. This is a sign that the REIT is able to attract tenants to its malls.
The REIT has deliberately short tenant leases, which give the managers more flexibility to improve the tenant mix and to increase rent in the future.
Potential downsides
There are, however, two downsides to Sasseur REIT’s existing portfolio. First, its four malls are leasehold. The tenures range from 27 to 35 years. Second, the REIT owns only four malls so there is an element of concentration risk. Nevertheless, I think its current portfolio still possesses more pros than cons.
2. A capable and honest management
Sasseur REIT has a relatively short track record as a listed REIT. Despite its short history, I think the way the managers are incentivised gives me confidence that they have minority shareholders at heart.
First, the entrusted manager has shown a good track record of growing the portfolio’s tenant sales. In addition, resultant rent, and consequently distribution per unit, have beaten expectations each and every quarter since the REIT’s listing. I am more inclined to trust managers that underpromise and overdeliver.
Additionally, both the REIT manager and the entrusted manager have incentives that are aligned with shareholders’ interest.
The entrusted manager is paid a base fee that is calculated as the lower of (1) 30% of gross revenue or (2) gross revenue minus EMA Resultant rent (what is paid to Sasseur REIT).
In essence, the entrusted manager is entitled to the leftover of gross revenue after paying what it owes to Sasseur REIT. However, this amount is capped at 30% of gross revenue. If there is left-over after the base fee and EMA resultant rent is paid to Sasseur REIT, the entrusted manager is then entitled to 60% of the leftover amount as a performance bonus.
From the way the entrusted manager is incentivised, it is clear that it is in the entrusted manager’s interest to try to grow gross revenue for the REIT, which is ultimately also beneficial to the REIT unitholders.
The REIT managers also have a base fee and a performance fee. The REIT managers are only entitled to the performance fee if it achieves distribution per unit (DPU) growth over the previous financial year.
3. A safe capital structure that can be optimised
Sasseur REIT has a gearing ratio of 29.0%, well below the regulatory ceiling of 45%. This gives it the debt headroom to take more loans to invest in new properties.
The REIT’s cost of debt is also manageable at 4.43% (reasonable by China standards). The relatively low interest rates give it an interest coverage of 4.8 times.
I also take heart in the fact that the manager has emphasised that they are going to be using the REIT’s financial muscle prudently. The manager will only look at yield-accretive acquisitions that can benefit unitholders over the long-term.
4. A fair and responsible sponsor
As a first-time REIT sponsor, investors don’t have much information to judge Sasseur Limited.
However, the sponsor has not interfered much in the way that Sasseur REIT has been run. It has not shown that it will treat minority shareholders unfairly.
On top of that, the sponsor also has a lineup of right-of-first-refusal properties in its portfolio that Sasseur REIT can tap on for future acquisitions.
As one of the largest outlet mall operators in China, it also boasts the experience and know-how that Sasseur REIT can use as it seeks to expand its portfolio in the future.
Based on and despite the limited information I have, I am fairly satisfied with the sponsor.
5. A decent valuation
Valuation is the final aspect to consider. Sasseur REIT has seen its share price soar over the past 12 months. It currently sports an annualised distribution yield of 7.4%.
When I bought it earlier this year, the REIT had a yield of 9.8%. Based on the lower yield today, the REIT seems expensive now.
But investors should note that at the time of writing, REITs in Singapore have an average yield of around 6%. This makes Sasseur REIT’s current 7.4% yield look comparatively cheap. As such, it may be that Sasseur REIT was trading at an unfairly low valuation earlier this year, rather than an overly rich price today.
The Good Investors’ Conclusion
Despite the recent run-up in price, Sasseur REIT still looks like an attractive stock to hold. The REIT ticks many of the right boxes and seems primed to continue increasing its distribution per unit.
There are risks to note. The REIT has high concentration risk, currency risk and is highly dependent on economic tailwinds. But despite these risks, I think the REIT’s positive traits and growth potential still give me an excellent risk-reward profile.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Being greedy when others are fearful is easier said than done. Most investors may say they would do it but few actually practice it.
In the last downturn, how many of us actually had the courage to buy stocks when everyone else was selling? So why is it so hard to act against the grain?
Fundamentals change too
When we think of market downturns, we usually imagine a world where nothing changes except for stock valuations. The reality, however, is nothing like that. Morgan Housel from the Collaborative Fund explains:
“The reason you may embrace ideas and goals you once thought unthinkable during a downturn is because more changes during downturns than just asset prices.”
Take 2008 for example. Stock prices fell hard, but not without reason. The subprime mortgage crisis in the United States developed into a full-blown international banking crisis. Previously sound banks failed, companies went broke and consumer spending plunged.
These are fundamental changes that caused a decline in company earnings, huge layoffs and reduced consumer wealth.
In such times, it is easy to see why investor confidence was sapped.
People need positive reinforcement
Even when we do think differently from the crowd, most of us are not able to act on it. People require positive reinforcement to take action.
For instance, when we are bullish on a stock, we need encouragement from external sources. We seek out positive reinforcement in the mode of brokers’ opinions, analysts reports, or even friend’s approval.
However, in a time when everyone is fearful, positive reinforcement is hard to come by.
Fear is hard to ignore
Emotions also play a huge part in our investment decisions. When we start investing, we often tell ourselves to ignore emotions and to focus on facts. But, unfortunately, it is extremely difficult to tune out emotions completely.
In his book The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy, investor James Montier said, “It turns out there are numerous human traits that push us toward conformity and away from individual thinking.”
He explains that neuroscientists have found that when individuals take the road-less-travelled, they experience fear. Fear is there for a reason. It is a defense mechanism that is built to protect us. Acting against our fears, is thus, innately difficult.
As such, it is no wonder that fear plays a big part in our investing decisions. When the stock market is raging, investors have a fear of missing out (FOMO), while the fear of losing money makes people sell in a bear market.
Contrarian Thinking
“ …don’t be led astray by Wall Street’s fashions, illusions and its constant chase after the fast dollar. Let me emphasize that it does not take genius to be a successful value analyst, what it needs is, first, reasonably good intelligence; second, sound principles of operation; and third, and most important, firmness of character.”
Benjamin Graham
It is not difficult to see why contrarian investing is so challenging. If it were easy, it wouldn’t be called “contrarian” in the first place. But on the other end of the spectrum, simply being contrarian for the sake of it, is also extremely detrimental. We need to seek the right balance.
For us to be a successful contrarian investor, we need three key characteristics: The ability to digest and analyst facts; individual thinking; and the courage to overcome fear. If you master these three traits, you will likely reap the rewards in the future.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Robo advisors have grown in popularity in recent years. But before hopping on the bandwagon, here are some things to note about them.
With the improvement in artificial intelligence, it was only a matter of time before robots started managing money. Today, robo advisors are becoming commonplace among retail investors. Even traditional banks such as DBS are beginning to embrace the power of artificial intelligence as a wealth management platform.
But should you trust a “robot” to manage your hard-earned money? With that in mind, I map some of the advantages and downsides of using a robot-assisted wealth management tool.
What really are robo advisors?
Robo advisors are digital platforms that personalise the investor’s portfolio using an algorithmic-driven approach with little human supervision.
The process is really quite simple. Investors register for an account on the robo advisor’s platform. They then answer a few questions that help the robo advisor understand the individual’s financial goals and risk tolerance.
Using an algorithm, the robo advisor then advises the clients on a suitable portfolio for them.
Usually, robo advisors have a fixed list of Exchange Traded Funds (ETFs) or funds that it can choose from to build the client’s portfolio. These funds, in turn, invest in a variety of assets, such as stocks, bonds, or real estate. One thing to note, these funds are actually mostly managed by humans! So robo advisors simply help to allocate your wealth to the funds that it thinks suits your needs and goals.
What are the fees involved?
Robo advisors usually charge just a basic annual advisory fee that is a small percentage of the total assets under management.
For instance, Morgan Stanley’s Access Investing charges a fee of 0.35% per annum, while DBS digiPortfolio charges an annual fee of between 0.75% and 0.85%.
But to be clear, this does not include the fees related to owning shares of mutual funds and exchange-traded funds. I will explain more on this later.
The table below shows the fees charged by the prominent robo advisors in Singapore.
The beauty of robo advisors is that it removes emotional misjudgments and other possible conflicts of interest from the decision-making process.
The robo advisors use a methodological process that is immune to emotion and is not influenced by commission-related fees.
They are also really simple to use. The set up is usually a seamless process and the minimum outlay to invest can be fairly small.
They also offer regular statements that will give investors up-to-date information on how their investments are performing and keep track of all additional cash flows.
In addition, robo advisors can automate the rebalancing of the portfolio for the client. This removes the hassle of actively managing your portfolio and reallocating it manually every few quarters. Importantly, there is also no additional transaction cost for rebalancing, unlike a do-it-yourself portfolio.
Potential pain points
But as with any product, there are also things not to like about robo advisors.
Robo advisors only offer a few different fixed portfolios. It is not possible to deviate from these fixed portfolios. After answering a few questions, the robo advisor will recommend one of the fixed portfolios that they have built. Investors cannot deviate from these fixed portfolios and are not able to access funds that are not offered on the platform.
On top of that, the robo advisor’s advisory fee is an additional cost. As mentioned earlier, investors have to pay the advisory fee, on top of the total expense ratio of the funds that they invest in through the robo advisor.
Although the robo advisory fee is usually less than a percentage point, it quickly adds up over the years.
Is it right for you?
Ultimately, the fewer potential conflicts of interest and the fee-based structures make robo advisors a robust wealth management tool that has the client’s interest at the forefront.
However, they still have their limitations. If you want a more personalised portfolio, the limited number of portfolio constructions in a robo advisor platform may not be sufficient.
Many of the robo advisors also only offer ETFs on their platform. As a result, it may not be useful for investors who want exposure to more aggressively-managed active funds, which have the potential for higher returns.
All things considered, I believe investors who want a simple stress-free passive investment strategy can consider using robo advisors. More savvy investors who are willing to do some research on funds should have a more hands-on approach to save costs and gain access to better-performing funds in the market.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Although Hyflux has found a white knight, its investors still don’t have much to smile over. Here are the important lessons we can learn from Hyflux.
News broke yesterday that the embattled water treatment firm Hyflux has finally signed a S$400 million rescue deal with Utico, a utilities company based in the Middle East.
Although Hyflux has now been given a lifeline with Utico injecting capital, shareholders and creditors of the water treatment company don’t have much to smile over. There are important lessons we can learn from Hyflux’s experience.
Painful lifeline
Hyflux and Utico’s agreement came after months of talks between the two. It had also been over a year since Hyflux filed for bankruptcy protection in May 2018 and suspended the trading of its ordinary shares, preference shares, and perpetual securities.
The rescue deal will see Utico take a 95% stake in Hyflux at a value of S$300 million. This means that all of Hyflux’s existing owners of ordinary shares will emerge holding 5% of the company, with a value of merely S$15.8 million. Just prior to the May 2018 trading suspension, Hyflux had a total market value (or market capitalisation) of S$165 million. In other words, Hyflux’s ordinary shareholders are now facing a haircut of around 90%.
Meanwhile, there are 34,000 individuals who hold Hyflux’s preference shares and/or perpetual securities that collectively have a face value of S$900 million. Utico’s rescue deal will see these 34,000 individuals receive total payment ranging from only S$50 million to S$100 million. Even at a S$100 million payout, the owners of Hyflux’s preference shares and perpetual securities are still staring at a loss of 89%.
Avoiding disasters
It’s great timing that a user of the community forums of personal finance portal Seedly asked a question yesterday along the lines of “How can we avoid Hyflux-like disasters?” I answered, and I thought my response is worth sharing with a wider audience, hence me writing this article. Parts of my answer are reproduced below (with slight tweaks made for readability):
“I’m not a pro, nor will I wish anyone to follow my investing thoughts blindly. But I used to write for The Motley Fool Singapore, and I wrote a piece on Hyflux in May 2016 when the company issued its S$300 million, 6% perpetual securities [the offering was eventually upsized to S$500 million].
The Fool SG website is no longer available, but there’s an article from The Online Citizen published in June 2018 that referenced my piece.
Back then, I concluded that Hyflux’s perpetual securities were risky after looking through the company’s financials. That was because the company had a chronic inability to generate cash flow and its balance sheet was really weak. Those risks sadly flared up in 2018 and caused pain for so many of the company’s investors.
What I wrote was this: “According to data from S&P Global Market Intelligence, Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015. Meanwhile, the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98, which isn’t low.””
What I shared was the financial traits I found in Hyflux that made me wary about the company. The great thing about those traits are that they can be applied to most situations in investing.
Simple rules
In my response to the Hyflux question in Seedly, I also mentioned (emphasis is added now):
“There are many things about a company to look at when investing. But I believe there are some simple rules that can help us avoid trouble. The rules are not fool-proof and nothing is fool-proof in investing, but they do work in general. The rules are: (1) Be careful when a company is unable to produce cash flow from its business consistently; and (2) be careful when the company’s balance sheet is burdened heavily by debt.”
The parts in italics above are rules that I believe are simple, yet incredibly effective. They also form part of my investment framework. Those rules are sometimes meant to be broken, as is the case with my decision to stay invested in Netflix, which has trouble generating cash flow and a heavy debt load for a good reason. But if we stick to the two rules with discipline, I believe we can keep ourselves out of trouble in the stock market most of the time.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Most Financial advisors prescribe diversifying into multiple asset classes. However, I invest solely in stocks. Here’s why.
Professional financial advisors prescribe diversifying one’s investment portfolio across multiple asset classes. This means spreading your investments into each of the four major asset classes- stocks, bonds, real estate, and commodities. In theory, this helps to smoothen returns and reduces the “risk” in the portfolio.
So having a portfolio that is composed entirely of stocks is unconventional, to say the least. However, before you close this article and call me a nut job, let me explain the reasoning behind my asset-allocation strategy.
Stocks: the best-performing asset class
Stocks are unlike any asset class. Eddy Elfenbein, portfolio manager of the AdvisorShares Focused Equity ETF, explains in his blog:
“All other assets are things. They just sit there. If you buy some gold and leave it alone, in 50 years it will still be there, just sitting there. There are income-producing assets like bonds and real estate, which makes them a little better than commodities. But still, they’re just things. They can neither think nor create.
Equity, on the other hand, is wholly different. It’s a legal entity by which people can come together and employ said assets to make goods and services for people… The business works to make a profit, and it keeps investing those profits in the business to make still more profits.”
When you invest in stocks, you are really investing in the power of human ingenuity.
It is, therefore, not surprising to note that over the long term, stocks are by far the top-performing asset class. In fact, according to data from the University of Chicago, in the 100 years from 1915 to 2014, stocks had an average real return (after removing inflation) of 8.3% per year, while bonds returned just 1.1% per year. A $1000 investment in bonds in 1915 would have a “real worth” of $2,992 in 2014, while $1000 invested in stocks would have been worth $2,301,134.
Other studies also consistently show that over the long-term stocks always come up on top, followed by bonds, real estate, and commodities.
The power of time
But performance alone is not the only reason to invest solely in stocks. I also need to be able to ride out the inevitable market swings in the stock market. Thankfully, I have time on my side. As a young investor, I have the holding power to see out the downturns of the market. I do not foresee needing the money from my investments anytime soon, nor do I depend on cash flow from my investments.
On top of that, my investment objective is really to grow my retirement fund as fast as possible, rather than simply preserving wealth. This makes stocks the ideal investment asset for me.
I can also still be sufficiently-diversified even if I solely invest in stocks. Investing in a range of different companies that operate in different geographies and sectors help to diversify my risk. I can even gain exposure to real estate, by investing in real estate investment trusts (REITs), which are also traded on stock markets.
Building your portfolio
Legendary investor, Peter Lynch, once said, “Gentlemen who prefer bonds don’t know what they’re missing.”
If you are a young investor and have a long investment horizon like I do, having a more aggressive investment portfolio might be the right way to go. However, investing solely in stocks does come with caveats. Investors need to be able to stomach inevitable market swings and steep drawdowns. Having a disciplined long-term approach and sticking to your principles is key to success in the market.
Over the long-term, I take heart that despite the volatile nature of stocks, if history is anything to go by, my stock-heavy portfolio will likely provide better returns than if I diversify across multiple other asset classes.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
My family’s portfolio has owned Netflix shares for eight years, and this is why we continue to own it.
Netflix (NASDAQ: NFLX) is one of the companies that’s in my family’s portfolio. I first bought Netflix shares for the portfolio in September 2011 at a price of US$26, again in March 2012 at US$16, and yet again in August 2017 at US$170. I’ve not sold any of the shares I’ve bought.
The company has done really well for my family’s portfolio, with its share price rising to around US$300 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Netflix’s shares.
Company description
Netflixis based and listed in the US. When it IPO-ed in 2002, Netflix’s main business was renting out DVDs by mail. It had 600,000 subscribers back then, and had an online website for its members to access the rental service.
Today, Netflix’s business is drastically different. In the first nine months of 2019, Netflix pulled in US$14.7 billion in revenue, of which 98% came from streaming; the remaining 2% is from the legacy DVD-by-mail rental business. The company’s streaming content includes TV series, documentaries, and movies across a wide variety of genres and languages. These content are licensed from third parties or produced originally by Netflix.
Many of you reading this likely have experienced Netflix’s streaming service, so it’s no surprise that Netflix has an international presence. In the first nine months of 2019, 48% of Netflix’s revenue came from the US, with the rest spread across the world (Netflix operates in over 190 countries). The company counted 158.3 million subscribers globally as of 30 September 2019.
Investment thesis
I will describe my investment thesis for Netflix according to the investment framework (consisting of six criteria) that I previously laid out in The Good Investors.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
Netflix already generates substantial revenue and has a huge base of 158.3 million subscribers. But there’s still plenty of room for growth.
According to Statista, there are 1.05 billion broadband internet subscribers worldwide in the first quarter of 2019. Netflix has also been testing a lower-priced mobile-only streaming plan in India. The test has done better-than-expected and Netflix is looking to test mobile-only plans in other countries too. Data from GSMA showed that there were 3.5 billion mobile internet subscribers globally in 2018.
I’m not expecting Netflix to sign up the entire global broadband or mobile internet user base – Netflix is not in China, and I doubt it will ever be allowed into the giant Asian nation. But there are still significantly more broadband and mobile internet subscribers in the world compared to Netflix subscribers, and this is a growth opportunity for the company. It’s also likely, in my view, that the global number of broadband as well as mobile internet users should continue to climb in the years ahead. This grows the pool of potential Netflix customers.
For another perspective, the chart immediately below illustrates clearly that cable subscriptions still account for the lion’s share of consumer-dollars when it comes to video entertainment. This is again, an opportunity for Netflix.
Subscribers to online subscription video services across the world has also exploded in the past few years. This shows how streaming is indeed a fast-growing market – and in my opinion, the way of the future for video entertainment.
As a last point on the market opportunity for Netflix, as large as the company already is in the US, it still accounts for only 10% of consumers’ television viewing time in the country, and even less of their mobile screen time.
2. A strong balance sheet with minimal or a reasonable amount of debt
At first glance, Netflix does not cut the mustard here. As of 30 September 2019, Netflix’s balance sheet held US$12.4 billion in debt and just US$4.4 billion in cash. This stands in sharp contrast to the end of 2014, when Netflix had US$900 million in debt and US$1.6 billion in cash. Moreover, Netflix has lost US$9.3 billion in cumulative free cash flow from 2014 to the first nine months of 2019.
But I’ll explain later why I think Netflix has a good reason for having so much debt on its balance sheet.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Netflix is led by CEO Reed Hastings, 58, who also co-founded the company in 1997. The long-tenure of Hastings in Netflix is one of the things I like about the company.
Although Hastings is paid a tidy sum to run Netflix – his total compensation in 2018 was US$36.1 million – his pay has reasonably tracked the company’s revenue growth. From 2014 to 2018, Netflix’s revenue nearly tripled from US$5.5 billion to US$15.8 billion. This matches the 326% jump in Hastings’ total compensation from US$11.1 million to US$36.1 million over the same period.
Hastings also owns 5.56 million Netflix shares as of 8 April 2019, along with the option to purchase 4.50 million shares. His ownership stake alone is worth around US$1.7 billion at the current share price, which will very likely align his interests with other Netflix shareholders.
On capability and innovation
Netflix was an early pioneer in the streaming business when it launched its service in 2007. In fact, Netflix probably wanted to introduce streaming even from its earliest days. Hastings said the following in a 2007 interview with Fortune magazine:
“We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.”
When Netflix first started streaming, the content came from third-party producers. In 2013, the company launched its first slate of original programming. Since then, the company has ramped up its original content budget significantly.
The table below shows Netflix’s total content cash spending from 2014 to 2018. There are two things to note. First, total content spending has been increasing each year and has jumped by around 340% for the entire time frame. Second, around 85%, or US$11 billion, of Netflix’s content spending in 2018 was for original content. Netflix’s content budget for 2019 is projected to be around US$15 billion, most of which is again for original content.
Source: Netflix earnings
All that content-spending has resulted in strong subscriber growth, which is clearly seen from the table below. Netflix’s decade-plus head start in streaming – a move that I credit management for – has also given the company a tremendously valuable asset: Data. The data lets Netflix know what people are watching, and in turn allows the company to predict what people want to watch next. This is very helpful for Netflix when producing original content that keeps viewers hooked.
Source: Netflix earnings
And Netflix has indeed found plenty of success with its original programming.For instance, in 2013, the company became the first streaming provider to be nominated for a primetime Emmy. In 2018 and 2019, the company snagged 23 and 27 Emmy wins, respectively. From a viewership perspective, the third season of Stranger Things (I love the show!), launched in the third quarter of 2019, had 64 million households tuning in within the first month of its release. Adam Sandler’s comedy film, Murder Mystery, welcomed views from over 73 million households in the first month of its release in June this year.
The move into originals by management has also proved to be prescient. Netflix’s 2019 second quarter shareholders’ letter name-dropped nine existing and would-be streaming competitors – and there are more that are unnamed. I think Netflix’s aforementioned data, and its strong library of original content, should help it to withstand competition.
I also want to point out the unique view on Netflix’s market opportunity that management has. Management sees Netflix’s competition as more than just other streaming providers. In Netflix’s Long-Term Viewletter to investors, management wrote:
“We compete for a share of members’ time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.
If you think of your own behavior any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.
We strive to win more of our members’ “moments of truth”.”
Having an expansive view on competition lessens the risk that Netflix will get blindsided by competitors, in my view.
4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour
Netflix’s business is built entirely on subscriptions, which generate recurring revenue for the company. As I already mentioned, nearly all of Netflix’s revenue in the first nine months of 2019 (98%) came from subscriptions to its streaming service, while subscriptions to the DVD-by-mail service accounted for the remaining small chunk of revenue.
But just having a subscription model does not equate to having recurring revenues. If your business has a high churn rate (the rate of customers leaving), you’re constantly filling a leaky bucket. That’s not recurring income. According to a recent estimate from a third-party source (Lab42), Netflix’s churn rate is just 7%, and is much better than its competitors.
5. A proven ability to grow
2007 was the year Netflix first launched its streaming service. This has provided the impetus for the company’s stunning revenue and net income growth since, as the table below illustrates. It’s good to note too that Netflix’s diluted share count has actually declined since 2007.
Source: Netflix annual reports
In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” I also said that “I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow.” So why am I holding Netflix shares when its free cash flow has cratered over time and is deeply in red at the moment?
This is my view on the situation. Netflix has been growing its original content production, as mentioned earlier, and the high capital outlay for such content is mostly paid upfront. But the high upfront costs are for the production of content that (1) could have a long lifespan, (2) can be delivered to subscribers at minimal cost, and (3) could satisfy subscribers who have high lifetime value (the high lifetime value is inferred from Netflix’s low churn rate). In other words, Netflix is spending upfront for content, but has the potential to reap outsized rewards over a long period of time at low cost. The shelf-life for good content could be decades, or more – for instance, Seinfeld, a sitcom in the US, is still popular 30 years after it was produced.
In Netflix’s Long-Term View shareholder’s letter, management wrote (emphases are mine):
“People love movies and TV shows, but they don’t love the linear TV experience, where channels present programs only at particular times on non-portable screens with complicated remote controls. Now streaming entertainment – which is on-demand, personalized, and available on any screen – is replacing linear TV.
Changes of this magnitude are rare. Radio was the dominant home entertainment media for nearly 50 years until linear TV took over in the 1950’s and 1960’s. Linear video in the home was a huge advance over radio, and very large firms emerged to meet consumer desires over the last 60 years. The new era of streaming entertainment, which began in the mid-2000’s, is likely to be very big and enduring also, given the flexibility and ubiquity of the internet around the world. We hope to continue being one of the leading firms of the streaming entertainment era.”
I agree with Netflix’s management that the company is in the early stages of a multi-decade transition from linear TV to internet entertainment at a global scale. With this backdrop, along with what I mentioned earlier on Netflix’s business model of spending upfront to produce content with long monetisable-lifespans, I’m not troubled by Netflix’s negative and deteriorating free cash flow for now. Netflix’s management also expects free cash flow to improve in 2020 compared to 2019, and “to continue to improve annually beyond 2020.”
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
I understand that Netflix’s free cash flow numbers look horrible at the moment. But Netflix is a subscription business that enjoys a low churn rate. It is also spending plenty of capital to pay upfront for long-lived assets (the original content). I believe that these provide the potential for Netflix to generate high free cash flow in the future, if it continues to grow its subscriber base.
Valuation
“Cheap” is definitely not a good way to describe Netflix’s shares. The company has trailing earnings per share of US$3.12 against a share price north of US$300. That’s a price-to-earnings (PE) ratio of around 100. But Netflix has the tailwinds of expanding margins and revenue growth. The company is currently on track to achieve its goal of an operating margin of 13% in 2019, up from just 4% in 2016. It is targeting an operating margin of 16% in 2020.
Let’s assume that in five years’ time, Netflix can hit 300 million subscribers worldwide paying US$12 per month on average. The lowest-tier plan in the US is currently US$9 per month, and Netflix has managed to grow its average revenue per user at a healthy clip, as shown in the table below.
Source: Netflix earnings
With the assumptions above, Netflix’s revenue in five years would be US$43 billion. If we apply a 20% net profit margin, the company would then earn US$8.6 billion in net profit. With an earnings multiple of just 30, Netflix’s market capitalisation in five years would be US$258 billion, nearly double from the current market capitalisation of US$134 billion. This equates to an annualised return of 14%. I think my assumptions are conservative. Higher subscriber numbers, higher average revenue per user, and fatter margins will lead to much higher upside.
The risks involved
There are three key risks that I see in Netflix.
First, Netflix’s cash burn and weak balance sheet is a big risk. I think Netflix’s strategy to produce original content is sound. But the strategy necessitates the spending of capital upfront, which has led to debt piling up on the balance sheet. I will be watching Netflix’s free cash flow and borrowing terms. For now, Netflix depends on the kindness of the debt markets – that’s a situation the company should be getting itself out of as soon as possible.
Second, there’s competition. Tech giant Apple and entertainment heavyweight Disney recently launched their streaming offerings, and the space is getting more crowded as we speak. As I mentioned earlier, I think Netflix should be able to withstand competition. In fact, I think the real victims will be cable TV companies. This is not a case of Netflix versus other streaming options – this is a case of streaming services versus cable. Different streaming services can co-exist and thrive. And even if the streaming market has a shakeout, Netflix, by virtue of its already massive subscriber base, should be one of the victors. But I can’t know for sure. Only time will tell. Netflix’s subscriber numbers in the future will show us how it’s dealing with competition.
Third, there’s key-man risk. Reed Hastings has been a phenomenal leader at Netflix, but he’s not the only important member of the management team. Ted Sarandos, 54, Netflix’s Chief Content Officer, is also a vital figure. He has been leading Netflix’s content team since 2000, and was a driving force in Netflix’s transition into original content production that started in 2013. If Hastings and/or Sarandos were to leave Netflix for whatever reason, I’ll be concerned.
TheGood Investors’ conclusion
Despite already having more than 158 million subscribers worldwide, Netflix still has a large market opportunity to conquer. The company also has an excellent management team with integrity, and has an attractive subscription business model with sticky customers. Although Netflix’s balance sheet is currently weak and it has trouble generating free cash flow, I think the company will be able to generate strong free cash flow in the future.
There are certainly risks to note, such as a high debt-burden, high cash-burn, and an increasingly competitive landscape. Key-man departures, if they happen, could also significantly dent Netflix’s growth prospects.
But in weighing the risks and rewards, I think the odds are in my favour.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The price you had initially purchased Sembcorp Marine’s shares at is irrelevant in deciding whether you should hold or sell the shares now.
I participate in Seedly’s community forums by answering investing-related questions. Recently, there was a question along the lines of “What should I do with my Sembcorp Marine shares that are in the red?” I thought my answer is worth sharing with a wider audience. It is reproduced below (with slight tweaks made for readability).
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Hello! The price you had initially purchased Sembcorp Marine’s shares at is irrelevant in deciding whether you should hold or sell the shares now.
When it comes to any stock, we should constantly be assessing what its future business prospects look like and compare it to the current stock price. At any point in time, if you realise that the current stock price reflects a bright future whereas the actual future business prospects look relatively dimmer to you, then that’s a good time to sell.
I wish I could give you a holistic framework to assess the future prospects of Sembcorp Marine. But I don’t have one. Right now, the company’s revenue depends heavily on the level of oil prices. I don’t have any skill in determining how a commodity’s price will move in the future, so I’ve largely stayed away from stocks whose revenues rely on commodity prices.
When you make your decision about what to do with your Sembcorp Marine shares, you’ll have to make a judgement on how the company’s business will fare five to 10 years from now. This judgement will in turn depend on your views on how the price of oil changes in that timeframe.
There’s another wrinkle to the equation. Sometimes a stock’s price can still fall even when there’s a positive macro-economic change. In the case of the oil & gas industry, a company’s stock price could still decline despite rising oil prices, if said company’s balance sheet is very weak and it has significant trouble in generating positive free cash flow.
Right now (as of 30 September 2019), Sembcorp Marine’s balance sheet holds S$468 million in cash, but S$4.15 billion in total debt. These numbers give rise to net-debt (total debt minus cash) of S$3.68 billion, which is significantly higher than the company’s shareholders’ equity of $2.25 billion. In fact, the net-debt to shareholders’ equity ratio of 164% is uncomfortably high in my view.
If I look at data from S&P Global Market Intelligence, Sembcorp Marine’s free cash flow has also been negative in every year from 2014 to 2018, with the exception of 2016. There has been no improvement detected so far in 2019. The first nine months of this year saw the company produce negative operating cash flow and free cash flow of S$17 million and S$290 million, respectively.
A weak balance sheet and inability to generate free cash flow could be a toxic combination for a company. That’s because the company’s lenders may be concerned with the situation and demand even tougher borrowing terms in the future. This starts a vicious cycle of pricier debt leading to an even weaker ability to service and repay borrowings, resulting in even pricier debt.
Sembcorp Marine is fortunate because it has the backing of Sembcorp Industries (Sembcorp Industries owns the majority of Sembcorp Marine’s shares), which has the relatively more stable utilities business to act as a buffer. It’s worth noting too that Temasek Holdings, one of our local government’s investment arms, is a major shareholder of Sembcorp Industries. But it’s anybody’s guess as to how much support Sembcorp Industries is ultimately willing to provide Sembcorp Marine.
I hope what I’ve shared can give you useful context in making a decision with your Sembcorp Marine shares.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Factor-based investing is an approach that involves investing in stocks that exhibit a few or just one particular characteristic.
These characteristics could be value, quality, or size “factors” to name a few. For example, an investment approach based on the value factor will involve investing in stocks that trade at a relative discount to their peers, be it on a low price-to-earnings (PE) or price-to-book (PB) ratio.
Does factor-investing work?
The idea behind factor-based investing is that the factors that shape the investing approach should be highly correlated with positive investment returns. For instance, back-testing has shown that stocks that exhibit a low PE ratio have over the long-run outperformed the broader market.
Therefore, exposing your portfolio to stocks that exhibit these characteristics will, in theory, reward you over time.
Sieving the wheat from the chaff
But not all factor-based investing works. Choosing the right factor to invest in plays a huge part in your success.
Andrew Ang, BlackRock’s head of Factor Investing Strategies, explained in a recent article that investors need to be able to distinguish between factors that are simply “passing fads” and those that are “fundamentally-based.” He explained two criteria he uses to make the distinction:
Economic rationale
The factor should have an economic rationale for its return premium. In the world of Big data, it is easy to find coincidental correlations between a factor and returns. However, many of these correlations are due to chance.
By focusing on factors that have economic rationale which drives their outperformance, we can be certain that there is a legitimate and very real reason behind the correlation between performance and the factor.
Decades of data
For the retail investor, it is difficult to gather enough information to backtest a particular factor over decades or even longer. However, funds with access to big data, are able to use the information to see if a factor has a long-term correlation with performance.
Using factor-based investing
If you are thinking of using a factor-based approach for your investment portfolio, there are a few things to take note of.
First, define your investment goal and identify factors that can help you achieve your goals.
Second, not all stocks that exhibit a particular factor will produce similar returns. The correlation between factors and returns is based on a large amount of data comprising thousands of companies. As such, your portfolio needs to be heavily diversified in many companies that exhibit that factor.
Combining factors into a solid investing framework
There is good evidence that factor-based investing has worked well in the past.
However, investors need to identify the factors that are the most correlated with positive returns. It may also be useful to combine certain “style” factors together into a more robust investment framework. An investment framework can help you focus your portfolio on stocks that are even more likely to do well over the long-term.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Not every exchange-traded fund, or ETF, is built the same. Some can be dangerous. We can avoid th common pitfalls if we know where to look.
Exchange-traded funds, or ETFs, are rising in popularity. According to ETF.com, assets under management by US ETFs crossed the US$4 trillion mark earlier this year. That’s huge, to say the least.
It’s not hard to see why the investment vehicle is appealing. You can get wide diversification instantly with most ETFs. Expense ratios are typically low as well, enabling you to keep most of the returns generated.
But not all ETFs are the same. Before you invest in any ETF, you may want to take note of these eight key points.
1. What is an ETF
An ETF is a fund that is traded on a stock exchange, and it can be bought and sold just like any other stock on a stock exchange. An ETF can invest in all kinds of shares depending on the purpose of the fund, and there are many ETFs that aim to track the performance of a stock market index.
The gap between a positive macro-economic trend and stock price returns can be a mile wide.
For example, gold was worth A$620 per ounce at the end of September 2005 and the price climbed by 10% annually for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. But an index of gold mining stocks in Australia’s market, the S&P / ASX All Ordinaries Gold Index, fell by 4% per year from 3,372 points to 2,245 in the same timeframe.
In another example, you can refer to the chart below on the disparity between the stock market returns and economic growth for China and Mexico from 1992 to 2013. Despite stunning 15% annual GDP growth in that period for China, Chinese stocks actually fell by 2% per year. Mexico on the other hand, saw its stocks gain 18% annually, despite its economy growing at a pedestrian rate of just 2% per year.
So when finding themes to invest in via ETFs, make sure that the macro-economic theme you’re betting on can translate into commensurate stock market gains.
3. Replication method
ETFs can mimic the performance of a stock market index through two broad ways: Synthetic replication, or direct replication.
Synthetic replication involves the use of derivatives without directly investing in the underlying assets. It is the less ideal way to build an index-tracking ETF, in my view, because there is more complexity involved and hence a higher risk that a large proportion of the underlying index’s performance can’t be captured.
Direct replication has two sub-categories: (a) Representative sampling, where the ETF holds only a sample of the stocks within an index; and (b) full replication, which involves an ETF buying the same stocks in nearly identical proportions as the weights of all the stocks that make up an index.
You should try to invest in ETFs that use full replication if possible.
4. Reputation matters
Look for an ETF that is managed by a reputable fund management company. Vanguard, SPDR, iSHAREs, and Blackrock are just some examples of reputable ETF managers.
5. Track record
An ETF should ideally have a listing history of at least a few years, so that we can see how the ETF has actually done, instead of relying on the performance of the underlying index.
6. Watch your costs
The expense ratio (essentially all of the fees that you have to pay to the ETF’s manager and service providers) should be low. There’s no iron-clad rule on what “low” is, but I think anything less than 0.3% for the expense ratio deserves a thumbs-up.
Having a low expense ratio puts an ETF on the right side of the trend of investment dollars flowing toward low-cost index-tracking funds. This lowers the risk of an ETF’s manager closing the ETF down for commercial reasons.
7. The assets that are managed
An ETF’s assets under management (AUM) should be high – ideally more than US$1 billion. Having sizable AUM would also lower the chance that an ETF will close in the future. It’s not uncommon for ETFs to close. When a closure happens, it creates hassle on our part to find new ETFs to invest in.
8. Performance tracking
Lastly, you should look for a low tracking error. An ETF’s returns should closely match the returns of its underlying index. If the tracking error has been high in the past, there’s a higher chance that the ETF can’t adequately capture the performance of its underlying index in the future.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Established in 2010, Fundsmith is the largest mutual fund in the United Kingdom with £18bn assets under management.
Led by its founder, Terry Smith, the fund has more than doubled the market since its inception nine years ago. Investors who invested with Fundsmith from the get-go have earned a total return of 353.2%, or an annualised return of 18.3%, as of 31 October 2019. Comparatively, global equities in general “only” returned a cumulative total of 171.1% over the same time frame, or 11.7% annualised.
Its impressive performance makes FundSmith the number one performing fund in the UK. From its inception to the end of 2018, Fundsmith had a cumulative margin of 13% over the second-best fund and 188% over the average for the sector, which delivered a market-lagging 81.9% cumulative return.
Although I am not invested in the fund, I am extremely impressed by the way Fundsmith is managed. Terry Smith’s annual letter to shareholders is also filled with insightful comments and timeless lessons that we can apply in our own investing. With that, here are some of the key takeaways from Fund Smith’s latest annual report.
Stop trying to time the market!
We are all too familiar with market commentators warning of an impending bear market. Smith says:
“I can now trace back six years of market commentary that has warned that shares of the sort we invest in, our strategy and our Fund would underperform.
During that time the Fund has risen in value by over 185%. The fact that you would have forgone this gain if you had followed their advice will, of course, be forgotten by them if, or when, their predictions pay off for a period. I suggest you don’t forget it.”
Legendary investor Peter Lynch once said that “far more money has been lost by investors preparing for corrections than has been lost in corrections themselves.”
If you find yourself worried that the bull market has run its course, it will be wise to remember these words of advice.
Growth versus Value
Fundsmith’s investment strategy involves buying and holding fast-growing companies. This strategy has outperformed value investing over the last decade. However, with growth stocks reaching rich valuations, some market commentators believe that value investing may come back in favour.
In his annual shareholder letter, Smith outlines two main handicaps he sees in the value investing strategy:
“One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value.
Moreover, it is a much more active strategy. Even when the value investor succeeds in reaping gains from a rise in the share price to reflect the intrinsic value he identified, he or she needs to find a replacement value stock, and as events of the past few years have demonstrated, this is far from easy. Moreover, this activity has a transaction cost.”
Let time work its magic
FundSmith has a simple three-step investment strategy: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.
While some actively managed fund managers may scoff at the idea of the third point, it is actually one of the key reasons why Fundsmith has done so well since its inception. Smith explains:
“Minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 13.4% during the period. This is the highest level of annual turnover which we have undertaken to date, but it is still tiny in comparison with most funds.”
He adds:
“Why is this important? It helps to minimise costs and minimising the costs of investment is a vital contribution to achieving a satisfactory outcome as an investor.”
The low portfolio turnover ratio resulted in FundSmith having by far the lowest transaction costs among the 15 largest active equity funds in the UK.
In fact, Smith attached a table of the returns of the 15 funds over a 3-year and 5-year period and compared them to their transaction costs. There was, unsurprisingly, a strong correlation between funds with lower transaction costs and higher returns (With FundSmith sitting at the top of the pile).
Final Thoughts
Terry Smith has become one of the most successful fund managers of his generation. He has even been compared to the legendary Warren Buffett. From his investing principles above, it is easy to see why Smith has found so much success in an industry that has traditionally underperformed low-cost index funds. His guiding investment principals can also help retail investors invest better. If you want to read more of Terry Smith’s letters to shareholders, you can head here.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
