Jeremy Chia, Author at The Good Investors : Page 15 of 21

A Collection of Quotes From Legendary Investor Seth Klarman’s Letters

The annual shareholder letters from Seth Klarman provides us with insight to his thought process and invaluable wisdom to approaching investing.

Seth Klarman is a legendary investor. The Baupost Group, led by Klarman, has a reputation as one of the top-performing hedge funds in the world. In 2012, Bloomberg ranked it as the fourth best hedge fund in terms of net gains since inception (Baupost was established in 1982). Baupost is also reported to have earned an annual return of around 19% since inception as of 2010.

I recently got my hands on Baupost’s shareholder letters from 1995 to 2001 that are written by the low-profile Klarman. In it are insightful quotes that I think are worth sharing.

On the relationships between the past and the future

“Any contrarian knows that just as a grim present is usually a precursor to a better future, a rosy present may be a precursor to a bleaker tomorrow. Without me listing all the things that could go wrong, simply consider that none of these virtuous factors are cast in stone. Just as seeds are sown during the seven lean years that allow the seven fat years to ensue, so does the reverse hold true.”

In his 1995 letter, Seth Klarman rightly pointed out that the past is the past. A couple of good years in the past does not always indicate good years in the future and vice versa. We are now living at a time when these words ring louder than ever.

As investors, we should be aware that things can change rapidly when we least expect it.

Predicting the Dotcom bubble

“Even the slightest association with the Internet is cause for an upward thrust in a company’s share price. This is reminiscent of so many similar episodes over the last few decades, where everything from technology stocks to gambling shares to gold mines had their moment in the sun. We know the current mania will end badly; we do not know when.”

In a letter to shareholders in June 1996, Seth Klarman warned of the bubble emerging in internet stocks. Looking back, it seems obvious to us that Internet stocks were vastly overpriced and the bubble would soon burst. But hindsight is 20-20 and Klarman was one of the few investors who could see it at that time.

We all know by now what happened. In 1999, the dotcom bubble finally burst with the tech-heavy Nasdaq Composite Index subsequently falling by 78% from its peak.

On being adaptable

“Investors who find an overly narrow niche to inhabit prosper for a time but then usually stagnate. Those who move on when the world changes at least have the chance to adapt successfully.”

The investing environment has changed significantly over the past three decades.

For instance, investing in loss-making companies used to be frowned upon. But today, some of the best-performing stocks have been loss-making for numerous year. Netflix and Amazon are two prime examples of stocks whose values have skyrocketed despite them incurring losses in the last few years (Netflix is still making losses). But both these companies are increasingly worth more because of their sizeable market opportunity and their ability to easily turn a profit after reaching enough scale.

Investors who are able to adapt and use different investment approaches can maximise the opportunities afforded to them in the market.

On investing

“We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance with an offsetting dose of humility, always asking for whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.”

In his shareholder letter in December 1996, Klarman describes how he and the fund makes investment decisions. I believe this is a great analogy and applies to all investors.

On how value investing works

“Value investors should buy assets at a discount, not because a business trading below its obvious liquidation value will actually be liquidated, but because if you have limited downside risk from your purchase price, you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favour.”

As a proponent of value investing, Seth Klarman describes brilliantly how value investing works. If investors are able to purchase a stock that is trading well below its liquidation value, the stock is unlikely to fall much further. The investor, hence, can get the upside potential without the downside risk.

On the challenges of investing in a bear market

“In investing, nothing is certain. The best investments we have ever made, that in retrospect seem like free money, seemed not at all that way when we made them. When the markets are dropping hard and investment you believe is attractive, even compelling, keeps falling in price, you aren’t human if you aren’t scared that you have made a gigantic mistake.”

In his 1997 shareholder letter, Seth Klarman remarked how challenging it is to buy stocks in a falling market.

I believe many investors may have felt the same way when many REITs in Singapore fell by more than 50% in March this year. Even if we knew that REITs looked like attractive bargains after the fall, how many of us managed to pull the trigger to buy them at those discounted prices? Today, REITs have climbed steadily and investors who bought in just a few weeks ago would be sitting on some meaty gains.

Final words

Seth Klarman’s words in his shareholder letters contain an arsenal of insights and advice. If you want to read more of his letters 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.

Breaking Down The Relaxed Regulations on REITs in Singapore

The MAS has increased the gearing limit for REITs in Singapore and extended the deadline for REITs to pay out at least 90% of their distributable income.

In light of the challenges that real estate investment trusts (REITs) in Singapore are facing, the Monetary Authority of Singapore (MAS) has stepped in to relax the regulatory constraints for REITs. This is extremely timely and is welcome news for worried REIT investors.

In this article, I’ll summarise some of the key changes and what it means for REITs.

Extension of permissible time for REIT to distribute its taxable income.

REITs in Singapore are required to distribute at least 90% of their taxable income to unitholders to qualify for tax transparency treatment. Under the tax transparency treatment, a REIT is not taxed on its income that is distributed to unitholders.

Previously, REITs had to distribute this amount within 3 months of the end of its financial year. But MAS has now extended the deadline to 12 months for this financial year.

What does this mean for REITs?

This will give REITs a larger cash buffer for this difficult period, especially for REITs that intend to approve later collection of rents or provide rental rebates for their tenants. Such REITs will now have the cash buffer to pay off their expenses and interest payments first, while still supporting their tenants.

This is great news for REIT investors who may have been concerned that REITs who have cash flow issues will not be able to enjoy the tax benefits that REITs usually enjoy.

SPH REIT (SGX: SK6U) was the first REIT in Singapore to announce that it will retain a large chunk of its distributable income in its latest reporting quarter in anticipation that it will need the cash in the near future.

Higher leverage limit and deferral of interest coverage requirement

MAS has raised the leverage limit for REITs in Singapore from 45% to 50%. This gives REITs greater financial flexibility to manage their capital. Lenders will also be more willing to lend to REITs who were already close to the previous 45% regulatory ceiling.

MAS also announced that it will defer the implementation of a new minimum interest coverage ratio of 2.5 times to 2022.

What does this mean for REITs?

I believe that the pandemic could result in tenancy defaults. This, in turn, could result in lower net property income for some REITs in the near term, putting pressure on their interest coverage ratios.

The deferment of the minimum interest coverage ratio and the higher gearing limit will allow REITs to take on more debt to see them through this challenging period.

Investors who were concerned about REITs undertaking rights issues, in the process potentially diluting existing unitholders, can also breathe a sigh of relief. The increase in the gearing limit to 50% will enable REITs to raise capital through the debt markets rather than issuing new units at current depressed prices.

My take

The lightening of regulatory restrictions by MAS is good news for REITs. This is especially welcoming for REITs with gearing ratios that were already dangerously close to the 45% regulatory ceiling, such as ESR-REIT (SGX: J91U). It now can take on a bit more debt to see it through this tough period, without breaking MAS regulations.

At the same time, I would like to see REITs not abuse MAS’s new rules. They should still be prudent in the way they take on debt to expand their portfolio. Ideally, REITs that have expensive interest costs should be more careful about their debt load and not increase their debt beyond what they can handle.

I think this COVID-19 crisis is a great reminder for all REITs that they cannot take anything for granted and need to have safety measures in place to ride out similar challenges in the future.

How to Invest During This COVID-19 Period

Markets are volatile and earnings are likely to sink. Nobody knows when the economy will return to normal. How can we approach investing during COVID-19?

“Fear incites human action far more urgently than does the impressive weight of historical evidence.”
Jeremy Siegel, Stocks for the Long Run

The COVID-19 pandemic has thrown markets into a frenzy. The month of March was likely the most volatile period in stock market history. Traders were zig-zagging in and out of the markets, causing daily swings of up to 10% in the S&P 500.

COVID-19 is indeed a black swan event. No one really knows what will happen and how the market will pan out in the short-term. With so much uncertainty, what should long-term investors do now?

Focus on things that you can predict

There are many things we can’t predict in the stock market. But investing is not about accurately predicting everything that will affect stock prices. Instead, it’s about focusing on stuff that you can predict. It’s about investing in companies that are likely to succeed in the long-term.

Terry Smith is the founder of Fundsmith, the manager of the UK’s largest fund, Fundsmith Equity Fund. Here’s what Smith wrote in a recent letter to his investors:

“What will emerge from the current apocalyptic state? How many of us will become sick or worse? When will we be allowed out again? Will we travel as much as we have in the past? Will the extreme measures taken by governments to maintain the economy lead to inflation? I haven’t a clue. Rather like some of the companies we most admire, I try to spend very little time considering matters which I can neither predict nor control and focus instead on those which I can affect.”

Don’t forget that the stock market is the best place to invest for the long term

In times such as this, it is easy to forget that the stock market is actually the best place to invest your money for long-term returns.

According to data from NYU finance professor Aswath Damodaran, US stocks have outperformed bonds and cash by a wide margin over the long run. From 1928 to 2019, US stocks produced an annual return of 9.7%, while bonds (10-year treasuries) had a 4.9% return per year.

In a recent video, Motley Fool co-founder David Gardner shared:

“From day one, when we started the Motley Fool 27 years ago, we said three things. Number one, the stock market is the best place to be for your long-term money. Number two, the stock market tends to rise 9 to 10% a year. That includes every bad week, quarter, month, year, bear market… and number three, make sure that you are invested in a way that you can sleep well at night.”

Don’t try to time the bottom

One of the most-asked questions among investors today is “Have we reached the bottom?”

I think that nobody really knows the answer to that. But it should not stop us from investing.

If you insist on only buying at the trough, you might miss a few good opportunities. In fact, I’ve heard of stories of investors who planned to enter the market at the bottom but missed out when their preferred-bottom never came. As stocks rose and got more expensive, they couldn’t bring themselves to buy and missed out on years of gains.

Billionaire investor Howard Marks mentioned in his latest memo:

“The old saying goes, “The perfect is the enemy of the good.” Likewise, waiting for the bottom can keep investors from making good purchases. The investor’s goal should be to make a large number of good buys, not just a few perfect ones.”

But remember to pick the right stocks

If you intend to invest in individual companies rather than an index-tracking fund, then it is important to remember that not all companies are created equal.

The well-followed S&P 500 index in the US has risen steadily over the long-term but a lot of its return can be attributed to only a handful of outperforming companies.

In fact, my blogging partner Ser Jing reported an interesting statistic in an earlier article. He wrote:

“ A 2014 study by JP Morgan showed that 40% of all stocks that were part of the Russell 3000 index in the US since 1980 produced negative returns across their entire lifetime.”

That’s an astounding statistic and goes to show that simply investing in any random stock will not guarantee you positive returns, even if you hold for the long run.

Picking the right companies is as important as choosing the right asset class to invest in. It is perhaps even more important for times such as today, where poorly-managed companies with weak balance sheets are fighting for their survival. As Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”

Stay calm and keep investing…

It is an understatement that markets are volatile. We are also likely going to see sharp drops in earnings from many companies in the next few quarters. Already Starbucks has guided for a 46% fall in earnings for the first quarter of 2020 and I expect to see many more companies reporting similar if not worse figures than this.

However, over the long-term, I expect earnings for well-run companies to return and for life to eventually return to normal.

Instead of focusing on the next few quarter results, I am keeping my eye on long-term results and which companies can survive the current economic standstill.

Why Don’t Stocks Fall as Fast as Earnings?

Company earnings in the US are expected to fall drastically. Shouldn’t the S&P 500’s price go much lower then? Not if earnings normalise in the future.

Some investors may be wondering why stocks have not fallen more. The S&P 500 in the US has rebounded sharply in recent days and is now down by just 15% year-to-date.

Yet US companies are expected to see their earnings decline much more than 15% in the next few quarters. This will make their price-to-earnings ratios seem disproportionately higher than they were last year.

So why is there this gap between stock prices and earnings?

Discounted cash flow

The answer is that stock prices are not a reflection of a single year of earnings. Instead, it is the accumulation of the future free cash flow or earnings that a company will produce over its entire lifetime discounted back to today.

This economic concept is known as the discounted cash flow model. Investor Ben Carlson wrote a brilliant article on this recently.

For example, let’s assume Company ABC is expected to earn $10 per share per year for the next 10 years. After discounting future cash flows back to the present day, at an 8% discount rate, the company’s shares are worth $67.10.

But let’s assume that because of the COVID-19 crisis, ABC’s earnings in the first year is wiped out. But it still can generate $10 a year in the remaining nine years after that. Using the discounted cash flow model, ABC’s shares are still worth $57.84

Despite a 100% decline in earnings in the coming year, ABC’s share price is worth just 14% less.

Other bad case scenarios

There are worse scenarios that can play out, but as long as a company’s long term future cash flow or earnings remains somewhat stable, its share price should not fall as much as its near-term earnings.

For instance, let’s assume that instead of earning $10 per share in the coming year, Company ABC now makes a loss of $10 per share. But in year 2 onwards, business returns to normal and it can generate its usual $10 per share for the next nine years. In this case, Company ABC’s shares are now worth $48.58, or 28% less than before.

Let’s make the situation worse. Let’s assume Company ABC has a $10 per share loss in year 1 and has zero cash flow in year 2. Let’s also assume that business only returns to normal in year 3. Its shares, in this case, are still worth $40.01, a 40% decline.

History shows that stocks fall less than earnings

This is the reason why stocks tend to fall far less than short-term earnings declines. We can look at the Great Financial Crisis as a reference.

According to data from Nobel Prize-winning economist Robert Shiller, the S&P 500’s earnings per share fell 77.5% from $81.51 in 2007 to $18.31 in 2008.

But the price fell much less. The S&P 500 closed at 1520.71 in July 2007 and reached a low of 757.13 in March of 2009. That translated to a 50% decline in stock prices.

Simply put, a 77.5% decline in earnings translated to ‘only’ a 50% decline in stock price.

Not only did the S&P 500’s price fall much less than earnings, but the subsequent years have also shown that stocks may have fallen too low. Investors who bought in at the troughs of 2009 enjoyed better-than-normal returns over the next 10-plus years.

Assuming stock prices fall in tandem with one-year forward earnings is short-sighted and does not take into account all the future cash flows of a company.

Last words on the price-to-earnings ratio

I guess the takeaway for this post is that you should not be scared off stocks by the high price-to-earnings ratio of companies that will likely appear in the coming months (a high price-to-earnings ratio because of a large decline in earnings but less drastic fall in share price).

The fall in earnings, if only temporary, should logically only cause a small decline in the value of the company, especially if it can continue to make profits consistently over the extended future.

It is natural that the PE ratio will be high if a company’s earnings disappear in the coming year. But the disappearance of the earnings could be temporary. When COVID-19 blows over, some companies – not all – will see business resume.

For now, the PE ratio is a useless metric as earnings are battered down temporarily, making the figure appear disproportionately high. We should instead focus on normalised earnings and whether a company can continue to generate free cash flow in the future.

What To Look Out For When Singapore REITs Release Results

Some Singapore REITs will be providing quarterly updates soon. I’ll be keeping a close eye on any updates on rebates, distributions, and cashflow.

As an investor with a very long-term focus, I usually don’t pay much attention to quarter-to-quarter fluctuations in earnings. But these are not normal times. And as someone who invests in Real Estate Investment Trusts (REITs) in Singapore’s stock market, I will be paying close attention to the following elements in their upcoming earnings announcements.

Cash flow

I suspect that REITs will continue to record the usual rental income on the income statement. However, actually collecting the cash from tenants is a different matter.

In the next earnings release, I will be keeping an eye on the cash flow statement. In particular, I’m watching the changes to the cash flow from operation.

The most important thing to look at in the balance sheet is the changes to the “Trade and other receivables” line. If that number increases disproportionately, it could be a sign that some tenants have not been able to hand over their rental payment to the REIT.

Updates on how they will help tenants

The Singapore government has stepped in to support businesses that are impacted by the COVID-19 pandemic. Restaurants, shops, hotels and tourist attractions will pay no property tax for 2020.

Property owners, such as REITs, are expected to pass these cost savings onto their tenants.

In the coming earnings update, I will be keeping my ears peeled on how the REITs will pass on these cost savings to tenants. This could be in the form of rental waivers or simply cash rebates.

SPH REIT was the first REIT to commit to helping its tenants. It said in its latest earnings announcement:

“To assist our tenants, SPH REIT will pass on fully the property tax rebates from IRAS announced by the Singapore Government on 26 March 2020, which will be disbursed in a targeted manner. On top of the Government’s property tax rebates, SPH REIT has provided further assistance to help tenants through this difficult period. In February and March 2020, tenant rebates amounting to approximately S$4.6 million have been granted to those affected tenants. This is part of the Tenants’ Assistance Scheme under which SPH REIT has rolled out to provide tenants with rent relief for February and March.
SPH REIT will extend Tenants’ Assistance Scheme for the months of April and May, for which the rebates will be granted according to the needs of the tenants. For the most affected tenants, they will be granted rental rebates of up to 50% of base rent. In addition, the full property tax rebates will be passed on to these tenants. Effectively, the most affected tenants will have their base rents waived for up to 2 months.
For tenants who are required by the Government to cease operations such as enrichment centres, SPH REIT will grant a full waiver of rental for the period of closure.”

I think this is the right way to go for REITs. Although landlords are not obliged to support their tenants through rent waivers, I think that providing some aid could be beneficial in the long term. Tenants that get support are more likely to remain a going concern and consequently can continue to rent the space in the future.

Distribution per unit

REITs are required to pay out at least 90% of their distributable income to receive special tax treatment. However, I think many of the REITs may opt to distribute much less than that in the first quarter of 2020.

SPH REIT was the first to slash its distribution per unit. It cut its distribution for the quarter ended 28 February 2020 by 78.7% despite a 12.2% increase in income available for distribution.

There are a few reasons I believe more REITs will follow in SPH REIT’s footsteps.

First, they may need the cash to tide them through the rest of the year if they foresee rental defaults or lower occupancy.

Second, as demonstrated by SPH REIT, some REITs are using their own cash to help tenants ride out this challenging period.

And third, the REIT is only required to pay out more than 90% of distributable income within the whole financial year. So REITs may opt to keep the cash first as a precaution. If the REIT doesn’t need the cash in the future, it can always distribute it in future quarters.

Updates on a rights issue

With REIT prices slashed this year, the last thing that investors want is a REIT being forced to raise money through a rights issue.

Unfortunately, this may be the case for REITs that are highly geared and that have trouble paying their interest expenses.

In addition, if a REIT’s rental yield falls, asset prices may decline and gearing levels will rise. REITs with a high debt-to-asset ratio may, in turn, have to pay higher interest rates when they refinance their loans. As such, it is possible that REITs with a high gearing ratio may choose to raise capital through a rights issue to deleverage their balance sheet.

Challenging times for REITs…

REITs are not spared in this challenging period for business.

Investors of REITs should pay close attention to the news the next few months to see which REITs are best positioned to ride out these unprecedented times.

Singapore Stocks That May Face a Liquidity Crunch

COVID-19’s economic impact is being felt by many companies. Those with high fixed costs, weak balance sheets, and disrupted businesses could be fighting for survival.

By now, you might have heard that Singapore Airlines Ltd (SGX: C6L) is being saved by Temasek who promised to inject capital into the debt-ridden company. But our flag carrier is not the only company that may need saving.

Many local businesses in Singapore face an existential crisis in these challenging times. Companies that (1) have high fixed expenses, (2) have insufficient cash on the balance sheet, and (3) face major disruption to their business, are most at risk.

Here are some Singapore-listed companies that could be fighting for their survival in the coming weeks and months.

Neo Group (SGX: 5UJ)

Singapore’s leading food catering company is high on the list. As of 31 December 2019, Neo Group had S$20.4 million in cash and equivalents but S$34.9 million in short term bank borrowings that need to be repaid within a year. On top of that, it also had $45.7 million in long term debt.

Neo Group’s food catering business has also likely been heavily disrupted due to the recent restrictions on gatherings of more than 10 people. The extent of the problem is made worse as Neo Group’s catering segment was its most profitable business in the financial year ended 31 March 2019.

The company also has a substantial amount of fixed costs. In the last quarter, Neo Group incurred S$14 million in employee expenses and S$1.1 million in finance costs. These are overheads that are unlikely to go away, even as orders dry up. Given Neo Group’s weak balance sheet, it could face difficulty obtaining a loan to bridge it through this challenging period.

Sembcorp Marine (SGX: S51)

Another one of Temasek’s investments, Sembcorp Marine could face a similar fate to Singapore Airlines. Sembcorp Marine is highly dependent on the health of the oil industry and faces major disruptions to its business amid tumbling oil prices (oil prices are near 20-year lows now).

Like Neo Group, Sembcorp Marine has more short-term debt than cash on its balance sheet. That’s extremely worrying given that credit may dry up during this trying times. As of 31 December 2019, Sembcorp Marine had S$389 million in cash and a staggering S$1.42 billion in short-term borrowings. In addition, the company had S$2.98 billion in long-term debt.

And let’s not forget that Sembcorp Marine also has heavy expenses. In the quarter ended 31 December 2019, Sembcorp Marine racked up S$29 million in finance costs alone and also had a negative gross margin. The company also spends heavily on capital expenditures just to maintain its current operations. Sembcorp Marine was free cash flow negative in 2019 after spending S$316 million in capital expenditures.

Sakae Holdings (SGX: 5DO)

Restaurant operator Sakae Holdings has been on the decline in recent years. Even before the COVID-19 pandemic began, revenue and earnings for the company have plunged. In the six months ended 31 December 2019, Sakae’s revenue fell 13.9% and it reported a S$1.56 million loss.

Worryingly, Sakae looks likely to run into cash flow problems in the very near future. As of 31 December 2019, Sakae had S$4.3 million in cash but near-term bank loans amounting to S$45.7 million.

I don’t see how Sakae can pay back its debtors and I doubt it can negotiate to refinance such a large sum over the next 12 months.

The COVID-19 crisis could be the straw that breaks the camel’s back for Sakae Holdings.

My conclusion

Obviously this is not an exhaustive list of companies in Singapore’s stock market that could face a liquidity crisis in these trying times. The pause in the global economy (Singapore’s included) will definitely impact many more companies than those I listed.

Companies that are not prepared and do not have the resources to ride out this period could be in big trouble. Companies that go broke will see a steep fall in their share prices and shareholders will get very little or nothing back if a company is forced into liquidation.

Why I’m Not Buying Singapore Airlines Shares Even After Temasek Promised To Save It

Temasek is underwriting a massive rights offering that will provide Singapore Airlines with much needed capital. But here’s why I’m still not convinved.

Much ink has been spilt on the whole Singapore Airlines Ltd (SGX: C6L) fiasco.

The latest news now is that Temasek, one of the Singapore government’s investment arms, has stepped in to provide our country’s flag carrier with much-needed capital.

This comes as Singapore Airlines (SIA) is confronting liquidity problems due to its high debt load and fixed costs, and the disruption to its business because of the COVID-19 pandemic.

The rescue

In essence, Temasek, which currently owns around 55% of SIA, has underwritten a S$5.3 billion equity fundraising by the airline. Temasek has also underwritten a $9.7 billion issuance of mandatory convertible bonds (MCBs) by SIA; the MCBs will either be converted to shares in 10 years or redeemed before then. What this means is that Temasek will not only subscribe to all the rights and relevant bonds that it’s entitled to; it will also purchase any of the rights or bonds that other SIA shareholders do not want.

But despite Temasek coming in to save the day, I’m not interested in investing in SIA, even at these seemingly low prices.

How did it get into this situation in the first place?

Much like other airline companies, SIA is heavily leveraged due to the capital-intensive nature of its business. The high cost of replacing and upgrading SIA’s fleet has also led to negative free cash flow in four of the last five years.

To keep itself afloat, our flag carrier has been increasingly making use of the debt markets for its cash flow requirements. In fact, the company issued bonds to the public just last year to raise more capital. At the end of 2019, the airline had S$1.6 billion in cash, but S$7.7 billion in total debt.

The aviation industry is highly competitive too and the emergence of low-cost carriers have led to thinner margins for airlines.

The COVID-19 pandemic was the straw that broke the camel’s back as the significant loss of revenue (SIA recently cut 96% of its flight capacity) finally led to severe cash flow problems for the company and Temasek ultimately had to step in to save the day.

Temasek saving the day but shareholders will be diluted

Let’s be clear, this is not a government bailout. It is nothing like what the American airlines got from the US government, which included a massive grant.

SIA’s situation is simply a major shareholder promising to back the company when it sells new shares to raise capital.

The new shares will dilute existing shareholders if they don’t take up the rights issue. On top of that, the mandatory convertible bonds will also dilute shareholders in 10 years when they are converted, unless they are redeemed before then.

SIA shares seem cheap but it really is not

Under the rights issue portion of SIA’s latest fundraising exercise, existing shareholders of the airline will be given the opportunity to buy three new shares at S$3 per share for every two shares they own.

Based on SIA’s current share price of S$6.03, I will get shares for an average price of S$4.21 each if I buy in today and subscribe to the rights issue. That seems cheap – but it really is not.

As of 31 December 2019, SIA had a net asset value per share of S$10.25. But that will drop substantially after the rights issue.

The rights issue will increase shareholders’ equity from S$12.1 billion to S$17.4 billion, or an increase of 43% from 31 December 2019. At the same time, the number of shares will increase from 1.2 billion to 3 billion. After the dilution, the net asset value per share will fall to around S$5.80 per share based on SIA’s last reported financials.

I also expect SIA’s net asset value per share to fall even more than that because of the heavy losses suffered as a result of the COVID-19 pandemic.

In the quarter ended 31 December 2019, Singapore Airlines incurred about S$800 million in staff costs, S$210 million in aircraft maintenance expenses, and S$522 million in depreciation. Most of these fixed costs will likely still need to be accounted for during the period of near-zero flights, despite SIA grounding its planes. These costs add up to around S$0.50 per share per quarter.

Together with the upcoming dilution and the heavy losses, Singapore Airlines’ shares could have a net asset value of close to or even less than S$5.30 per share in the future, depending on how long the pandemic lasts.

Earnings per share dilution

Earnings per share will also fall after the issuance of new shares because of the rights issue. SIA reported trailing 12 months profit of S$765 million.

Even if our flag carrier can achieve similar profit after the whole pandemic passes, its earnings per share will drop substantially because of the larger number of outstanding shares.

By my calculation, normalised earnings per share will decline from S$0.63 to just S$0.25 after the rights issue.

I’m not buying shares just yet…

The injection of cash will put SIA in a much better financial position but I’m still not convinced.

Even if I buy shares today and subscribe to all my allotted shares in the rights issue, I don’t think I’ll be getting that great of a deal. I’ll be paying an average price of around S$4.21 per share, which translates to only a small discount to my calculated adjusted net asset value per share. It is also slightly more than 16 times SIA’s normalised earnings post-rights issue, which is not that cheap.

Moreover, if SIA is unable to redeem the mandatory convertible bonds before they get converted in 10 years time, they will potentially lead to further dilution to shareholders.

Let’s not forget too that our flag carrier (1) has a history of inconsistent free cash flow, (2) operates in an industry that is a slave to fuel prices, and (3) has strong competition from low-cost carriers.

Given all these, despite the seemingly low share price, I still don’t think Singapore Airlines shares are cheap enough for my liking.

Government Bailouts and What They Mean For Shareholders

US airlines are getting a massive US$60 billion bailout. Here’s a look at bailouts in the past and how shareholders have been impacted.

US airlines finally got something to cheer about.

Earlier this week, US senate leaders came to an agreement on a US$2 trillion stimulus bill. A whopping US$60 billion of that will be used to bail out struggling US airlines.

Airlines, in return, must forgo layoffs until the fall (sometime in the fourth quarter of 2020), accept limits on executive compensation and dividends, and maintain certain routes. Despite the limitations, I think this is a deal the airlines will happily take to save themselves from bankruptcy.

Bailouts are nothing new though. The US has a long history of bailing out companies that were deemed too important to fail. These companies either provided essential services, accounted for a decent chunk of the economy, or employed a large number of people.

But bailouts take different shapes and forms. The ways that the government injects cash into companies (or individuals), the kind of industries the government tries to save, and the impact on shareholders differ every time.

In light of the latest bailout, I decided to take a short trip down memory lane to see the different kinds of bailouts that have occurred.

The Great Depression

One of the greatest economic catastrophes of modern history occurred from 1929 to the early 1940s. It was the longest, deepest, and most widespread depression of the 20th century.

In 1933 US President, Franklin D. Roosevelt took the oath of office and started implementing solutions to bring the economy out of the recession.

One of the things he did was to bail out struggling homeowners. At that time, the national unemployment rate was around 25%, so many Americans who lost their jobs were unable to pay off their home mortgages and were left homeless.

The Home Owners’ Loan Corporation was set up to solve the problem. The newly formed government agency purchased defaulted mortgages from banks and refinanced them at lower rates, allowing about a million homeowners to benefit from lower mortgage rates.

This bailout was targetted at individuals at that time and kept people off the street. However, it was not until World War II ended that the depression was officially over and the post-war boom began.

The Great Financial Crisis

The next most important economic crisis occurred much more recently in 2007-2008. Known as the Great Financial Crisis, the collapse of Lehman Brothers amid the bursting of the housing bubble culminated in a global financial crisis.

However, this time, the US government’s response was swifter and the bailouts introduced saved banks, restored confidence, allowed banks to lend again, and eventually led to the 12-year bull market that ended this year.

So what did the US government do in 2008? The Emergency Economic Stabilisation Act of 2008, often called the “bank bailout,” was signed into law by then-President George W. Bush. The new law led to the creation of the US$700 billion Troubled Asset Relief Program (TARP) to inject capital into banks. But these funds were not given as grants, rather they were used to purchase toxic assets from the banks.

A key part of the US federal government’s plan was to buy up to US$700 billion of illiquid mortgage-backed securities. These were essentially a bundle of home loans packed into one.

On top of that, the US government injected cash into banks through the purchase of preferred stock. Citibank needed a particularly big injection of capital, with the government purchasing US$45 billion in preferred and common Citigroup stock. Selling stock when your share price is down 80% is never going to be pretty and Citigroup shareholders learnt that the hard way as they were diluted almost six-fold. Till today, Citigroup’s share price is still more than 80% off the high it reached in 2007. However, what the bailout achieved was to save Citigroup from insolvency and shareholders could at least survive to fight another day.

Overall, TARP improved the balance sheet and reduced the potential losses of banks and financial institutions.

The net effect for the government was also positive as it was reported that TARP recovered US$441.7 billion of US$426.4 billion invested, earning a US$15.3 billion profit when everything was done and dusted.

COVID-19 Crisis

Fast forward to today and we are once again seeing a massive bailout, this time with the aviation industry.

As mentioned earlier, struggling US airlines are getting an early Christmas present this year, to the tune of US$60 billion.

According to a draft of the legislation, airlines will receive up to US$25 billion in direct grants. That’s practically free money for the airlines as long as they promise not to layoff workers till the fourth quarter of 2020, accept limits on executive compensation and shareholder dividends.

Additionally, the bill also grants US$25 billion in loans and loan guarantees for passenger airlines and US$4 billion for cargo air carriers. The promise of loans will help struggling airlines raise much needed new capital even if the banks won’t lend to them.

The news is, of course, great for shareholders and employees. Employees get to keep their jobs while shareholders don’t have to worry about potential bankruptcies. The injection of cash will tide airlines through this challenging period. Airline shares have been creeping up since rumours of a bailout began.

The Good Investors’ conclusion

Bailouts may seem like a bad word but they are great for shareholders. The injection of cash into a company can tide them through when all hope seemed to be lost.

However, bailouts also bring to light that the company was not managing its finances well enough. Overleverage, bad investments, and in the case of Airlines, overspending on share buybacks destroyed their balance sheets to the brink of collapse.

Although bailouts can eventually save the day, they are one-off special situations and investors should never rely on them to get them out of trouble.

Is Zoom’s Stock Too Expensive Now?

Zoom’s stock has defied gravity, climbing around 30% in the past 30 days compared to the brutal 20%-plus fall for the S&P500. But is it too expensive now?

While stocks markets around the world plunged over the last month, Zoom Video Communications‘s (NASDAQ: ZM) share price has defied gravity, zooming up by close to 30%.

Investors are anticipating great things for the company this year as the COVID-19 epidemic accelerates the adoption of video conferencing tools around the globe.

With the hype surrounding Zoom, I thought it would be an opportune time to share some of my thoughts on the fast-growing company and whether it is still worth investing at today’s price.

Fast growth

Zoom is one of the fastest-growing listed software-as-a-service firms in the world today. That says a lot.

In fiscal 2020 (ended 31 January), Zoom recorded revenue of US$622.7 million, up a staggering 88% from a year ago.

New customers and a net dollar expansion rate of more than 130% contributed to the sharp rise in sales. Over the course of 2019, Zoom had 641 customers contributing more than US$100,000 in trailing-12-months revenue, an increase of 86% from a year ago.

Consistently strong performance

Last year’s growth was by no account a one-off. Zoom has been growing rapidly for the three years prior to its IPO in 2019. Annual revenue increased by 149% and 118% in fiscal 2018 and fiscal 2019, respectively.

The company’s net dollar expansion rate has also been north of 130% for seven consecutive quarters, a testament to the strength of the business platform.

COVID-19, a catalyst for greater use of Zoom’s tools

On top of the long-term tailwinds for video conferencing, the COVID-19 pandemic has accelerated the adoption of Zoom’s video conferencing tools. Many people – from university students to work-at-home employees – have begun using Zoom’s software as they take shelter at home.

My sister who has returned home from Australia during this COVID-19 outbreak is using Zoom’s software for “long-distance” tutorials. Fortune magazine reported that teachers are even conducting piano lessons through Zoom.

Huge addressable market

Video is increasingly becoming the way that individuals communicate with each other at work and in their daily lives. And Zoom is the market leader in the space.

Zoom addresses the Hosted/Cloud Voice and Unified Communications, Collaboration Application, and IP Telephony Lines segments within the communication and collaboration market. Market researcher International Data Corporation estimates that these segments would be worth US$43.1 billion by 2022.

Remember that Zoom’s trailing-12-months revenue is just US$622.7 million. That’s a mere 1.4% of the addressable market, so there’s plenty of room for Zoom to grow into.

A cash-generating business

Unlike some of the other fast-growing SaaS (software-as-a-service) companies, Zoom is already cash-flow positive. In fiscal 2020, Zoom generated US$151.9 million and US$113.8 million in operating cash flow and free cash flow, respectively. That translates to a healthy free cash flow margin of 18.3%, with room for further margin expansion as usage of Zoom’s services grows.

In addition, even after accounting for stock-based compensation, Zoom is still profitable, with GAAP (generally-accepted accounting principles) net income of US$21.7 million in fiscal 2020, or US$0.09 per share.

Zoom’s high gross margin of more than 80% enables it to spend a large chunk of its revenue to acquire customers and grow the business while still sustaining a decent free cash flow margin and squeeze out some GAAP profit.

A robust balance sheet

A time when many businesses are being momentarily put on hold due to the COVID-19 spread highlights the importance of a company with a strong balance sheet. Companies that have enough cash to pay off their fixed costs during pauses in sales are more resilient to economic hardships.

Although Zoom is thriving in the current COVID-19 situation, there could be other incidents that may cause temporary disruptions to its business. It is hence heartening to note that Zoom has a robust balance sheet.

As of 31 January 2020, the video conferencing software company had US$283 million in cash and no debt. In fact, Zoom has been so adept at generating cash flow that it said that much of the primary capital it had raised prior to its IPO was still on its balance sheet.

Competition threat

Competition is perhaps the biggest threat to Zoom. The video conferencing company faces competition from mega tech firms such as Google, which has the free Google Hangout video conferencing service. Facebook and Amazon have also spent heavily on video communication tools.

However, Zoom’s video-first focus has propelled it to become the market leader in the video conferencing space. Unlike other companies that added video tools to their legacy communication software, Zoom built a video-conferencing tool with video at the front and centre of its architecture. This focus gives Zoom users a better video conferencing experience.

For now, Zoom remains the forefront in this space with most users preferring its software over competitors but it must consistently add features and update its software to keep users on its platform.

But is it too expensive?

There is no doubt that Zoom has all the makings of a great company. The software-as-a-service firm is growing rapidly and already boasts free cash flow margins in the mid-teens range.

I foresee Zoom’s free cash flow growing much faster than revenue in the future as margins expand due to economies of scale. Moreover, the COVID-19 pandemic is accelerating the adoption of video conferencing software, which is great news for Zoom, being the market leader in this space.

Having said all that, Zoom’s stock has skyrocketed well above what I believe is reasonable. Zoom, which is still run by founder Eric Yuan, has a market cap of around US$38 billion currently.

That’s an astonishing 62 times fiscal 2020 revenue. Even if Zoom’s profit margin was 40% today (a level I think it can achieve in the future), its current market cap would still translate to 176 times earnings.

My conclusion

Based on its share price, the market is anticipating big things for Zoom in the coming quarters as more companies are forced to adopt video conferencing software. On top of that, Zoom, even before the COVID-19 outbreak, was already successfully riding on the coattails of a rapidly growing industry.

As an investor, I would love to participate in Zoom’s growth. However, I think Zoom’s stock is priced for perfection at the moment. Even if Zoom can deliver on all fronts over a multi-year time frame, investors who buy in at this price may still only achieve mediocre returns due to its high valuation.

As such, even though I wish I could be a shareholder of Zoom, I’ll happily wait at the sidelines until a more reasonable entry point arises.

Which S-REIT Could Face a Cashflow Problem?

REITs have fallen hard the last couple of weeks. Here’s a look at some REITs that could face cashflow issues if their tenants defaults.

It has been a nightmarish two weeks for Real Estate Investment Trust (REIT) investors in Singapore’s stock market.

Almost every S-REIT was massively sold down, with many losing more than 50% of their value. Investors who invested on margin were hit especially hard as their losses were amplified and they were forced into selling off positions at a loss.

Investors of REIT-ETFs also reportedly rushed to the exits, further exacerbating the situation.

It does not help that global economic activity has slowed down significantly because of COVID-19. Although most REITs will likely be able to weather this short-term storm, there are some that could face difficulties.

Last week, I published Which S-REIT Can Survive This Market Meltdown? In it, I said that some REITs may face a cashflow crisis if their tenants default on rent. This can lead to a vicious cycle of REITs struggling to pay their interest and end up having to sell assets or raise capital through rights offerings or private placements.

REITs that have a concentrated tenant base, high-interest expense, and less headroom to take on more debt (the regulatory ceiling is a 45% debt-to-asset ratio) are more at risk of a cashflow problem.

In this article, I will highlight some REITs that sport some of these unwanted characteristics.

High tenant concentration

REITs most at risk are those with tenants that cannot pay up their rent. Having a high tenant concentration means that the loss of revenue will be massive if the major tenant defaults.

Below are some S-REITs that have relatively high tenant concentration. Do note that this is not an exhaustive list, they are just some REITs that I have studied:

First REIT (SGX: AW9U): The healthcare REIT derived around 82% of its rental income from PT Lippo Karawaci Tbk and its subsidiaries in 2018.
EC World REIT (SGX: BWCU): The E-commerce and specialised logistics REIT owns China assets and is dependent on two major tenants: Hangzhou Fu Gang Supply Chain Co Ltd and Forchn Holdings Group Ltd. Combined, the two tenants contributed 67.4% of the REIT’s total rental income in 2018.
Elite Commercial REIT (SGX: MXNU): The UK-focused REIT rents practically its entire portfolio to the UK government.

High tenant concentration is risky but it also depends on the type of tenant that the REIT is renting to.

In First REIT’s case, its assets are healthcare properties such as hospitals and nursing homes. Business in healthcare properties should continue as usual during the COVID-19 pandemic, so the tenants will most likely have the means to pay its rent.

Elite Commercial REIT’s tenant is the UK government, which will almost certainly have the means to cover its obligations.

So, while it is important to think about tenant concentration, it is equally important to judge the likelihood of the main tenant defaulting.

High gearing

REITs that have high gearing will have little debt headroom to take on more borrowings if the need arises.

Below are some REITs that have gearing ratios that are close to the 45% regulatory ceiling.

ESR-REIT (SGX: J91U): With a gearing ratio of 41.5% at end-2019, the industrial REIT is one of the highest geared REITs in Singapore.
Cache Logistics Trust (SGX: K2LU): The logistics REIT has a gearing of 40.1% as of 31 December 2019.
Ascendas REIT (SGX: A17U): As of December 2019, the largest REIT in Singapore by market cap had a gearing ratio of 35.1%.

Again this is not an exhaustive list and not all REITs with a high gearing ratio will face default. However, REITs that have high gearing have less financial flexibility and may need to tap into the equity markets to raise money in the unlikely situation of a cashflow crisis. Tapping on the equity markets could mean dilution for a REIT’s existing unitholders.

Low interest coverage

For a simple but not exact definition, the interest coverage ratio compares a REIT’s interest expense against its net property income. A high interest coverage ratio means that the REIT is able to service its interest expense easily with its income.

In a time of crisis, it is important that a REIT’s rental income can at least cover its interest expense to tide things over. Defaulting on debt obligations can hurt a REIT’s credit rating and ability to negotiate lower interest rates in the future.

Here are some S-REITs with a low interest coverage ratio (again, it’s not an exhaustive list):

ESR-REIT: With its high gearing, ESR-REIT’s interest expense is naturally high compared to its rental income. As of 31 December 2019, it had an interest coverage ratio of 3.7 times.
EC World REIT: China-focused REITs traditionally have a higher cost of debt so its no surprise that EC World REIT has a low interest coverage ratio of just 2.5 times:
Ascendas India Trust (SGX: CY6U): Technically a business trust, Ascendas India Trust owns IT-related and logistics properties in India. It has an interest coverage ratio of 3.6 times.

The REITs above have low interest cover so a drop in rental income may result in their inability to pay their interest expense.

Wait and see…

The above-mentioned REITs have some of the unwanted characteristics that make them susceptible to cash flow issues. However, it is not clear whether they will end up facing tenant defaults.

Ultimately, whether the REIT can weather the storm comes down to if their tenants can meet their rental obligations. So far, none of the REITs have made any announcements of tenant defaults, so it is best not to panic yet. As a REIT investor, I have not sold any of my positions and I believe that most of the REITs in my portfolio will be able to weather this storm.

For the time being, I am taking a wait-and-see approach but will be keeping a close eye for any announcements or earnings updates.

*EDITORS NOTE: The article erroneously stated that Ascendas REIT had a gearing ratio of 39.9%. We have since edited to reflect the correct figure of 35.1%.