Articles for specific investing analysis : Page 13 of 14

Why I Own Berkshire Hathaway Shares

I’ve owned Berkshire Hathaway shares for more than eight years. There are good reasons why I continue to hold shares of Warren Buffett’s conglomerate.

Berkshire Hathaway (NYSE: BRK-B) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Berkshire shares for the portfolio in August 2011 at a price of US$70 and again in September 2015 at US$130. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with Berkshire’s share price being around US$223 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 Berkshire shares.

Company description

Berkshire is one of the most fascinating companies I have come across.

The story starts in 1965, when Warren Buffett took over the company because of anger. Back then, Buffett was a hedge fund manager. He had bought Berkshire shares a few years prior because they were cheap compared to the company’s assets.

In 1964, Berkshire’s then-leader, Seabury Stanton, offered to buy Buffett’s shares for US$11.50 each. Buffett agreed to sell. But Stanton’s official offer was slightly lower, at US$11.375 per share. Buffett was livid about being lied to, to the extent that he amassed a controlling stake in Berkshire to fire Stanton.

Berkshire was merely a struggling textile manufacturer when Buffett became its leader. But over the years, Buffett has thoroughly transformed the company through numerous inspired acquisitions and deft stock market investments.

Charlie Munger joined Berkshire in 1978. But for many years prior, he and Buffett were already collaborating. In fact, Munger helped Buffett to refine his already formidable investing prowess.

Today the 88-year old Buffett and 95-year old Munger continue to lead Berkshire as chairman and vice-chairman, respectively. The company can also be rightfully described as a truly diversified conglomerate, with more than 60 subsidiaries across a wide range of industries. Here’s a sample of the companies under Berkshire’s umbrella:

Berkshire Hathaway Reinsurance Group – provider of insurance products to other reinsurers and property, casualty, life, and health insurers globally
GEICO – second largest insurer in the US auto insurance market (share of 13% at end-2018)
Burlington Northern Santa Fe – one of the North American continent’s largest railroad companies
Berkshire Hathaway Energy – one of the largest energy utilities in the US, and the second-largest residential real estate brokerage firm in the same country
IMC International Metalworking Companies – among the top three manufacturers of consumable precision carbide metal cutting tools in the world
Precision Castparts – manufacturer of metal parts and components that go into aircraft
Borsheim’s – fine-jewellery retailer
Nebraska Furniture Mart – furniture retailer (as its name suggests)
See’s Candies – chocolate and confectionary producer

Berkshire’s reach extends beyond its subsidiaries. It also has a massive investment portfolio that is worth more than US$220 billion as of 30 September 2019. The portfolio consists of shares of more than 40 publicly traded companies that are mostly listed in the US. Some of them are also in my family’s portfolio, such as Apple, Amazon.com, and Mastercard. The investment portfolio is overseen by Buffett, Munger, Todd Combs, and Ted Weschler.

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for Berkshire.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Berkshire is already a massive company, with US$247.8 billion in revenue in 2018. But I believe there’s still plenty of room to run for the conglomerate, although I’m not expecting rapid growth.

I think a growth rate in the high single-digit or low double-digit percentage range for Berkshire is reasonable. This is because Berkshire’s diversified collection of US stocks and high-quality subsidiaries puts it in a great position to ride on the US’s long-term economic growth.

There are a few points I want to expand on. First is regarding the US economy. Over the years, Buffett has not been shy in sharing his enthusiasm about the US . In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind.

It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.

There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.

Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”

(Do read the “The American Tailwind” section of Buffett’s 2018 letter.)

To build on Buffett’s American Tailwind idea, I want to highlight that the working-age population in the US is estimated to increase by 13% from today to 2050. That’s one of the brightest demographics among developed economies across the world. Here’s a chart from Morgan Housel showing this:

The second point I want to expand on is the quality of Berkshire’s subsidiaries. If you’re a long-time observer of Berkshire, you’ll know that a durable competitive advantage is one of the key qualities that Buffett seeks when making acquisitions.

There are numbers to prove this point: Berkshire’s manufacturing, service, and retailing businesses earn healthy after-tax returns on net tangible assets while holding plenty of cash and using very little debt. The table illustrates this from 2012 to 2016 (the last year that Buffett reported the after-tax return on net tangible assets employed by this group of businesses).

*Source: Berkshire Hathaway annual reports*

A last note from me on Berkshire’s room for growth: Buffett and Munger are, in my eyes, two of the best investors in the world today, and they’re still constantly looking for bargains in the stock market and private businesses to acquire to strengthen Berkshire’s portfolio.

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 30 September 2019, Berkshire’s balance sheet has US$102.2 billion in borrowings – that’s a fair amount of debt.

But Berkshire also has a massive cash hoard of US$128.2 billion, including US$53.4 billion in short-term investments in US Treasury bills, which can be considered as cash for liquidity purposes. So Berkshire does have tremendous resources to invest for growth as well as withstand shocks.

There are huge insurance businesses within Berkshire. So I think it’s also important for me to watch the company’s ability to payout huge insurance claims from time to time.

Buffett believes that “the annual probability of a US mega-catastrophe causing [US]$400 billion or more of insured losses is about 2%.” For perspective, a US$400 billion insured-loss is nearly four times the highest amount that the US has seen since 1980. This is illustrated in the chart below (the dark blue bars indicate insured losses in each year):

*Source:* *Insurance Information Institute*

In the event that US$400 billion of insured losses happen in a year, Berkshire’s share would be just US$12 billion or so. This is a huge sum of money. But it is far less than the annual earnings the company expects from its non-insurance businesses. For context, Berkshire’s non-insurance businesses generated US$20.8 billion in pre-tax income in 2018, up 24% from 2017. Although Berkshire will be bruised by a US$400 billion mega-catastrophe event in the insurance industry, most other insurers would go bust according to Buffett.

The diversification present in Berkshire adds another layer of financial resilience. I mentioned earlier that the conglomerate controls over 60 subsidiaries across many industries. This is also true of Berkshire’s investment portfolio. The 40-odd stocks in the portfolio belong to technology, banking, media, consumer products, and more.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Buffett’s overall reputation, in business and in life, is pristine. The excerpt below, taken from Berkshire’s latest official proxy statement released in March 2019, will also shine tremendous light on the integrity of Buffett and Munger (emphases are mine):

“Due to Mr. Buffett’s and Mr. Munger’s desire that their compensation remain unchanged, the Committee has not proposed an increase in Mr. Buffett’s or Mr. Munger’s compensation since the Committee was created in 2004. Prior to that time, Mr. Buffett recommended to the Board of Directors the amount of his compensation and Mr. Munger’s.

Mr. Buffett’s annual compensation and Mr. Munger’s annual compensation have been [US]$100,000 for more than 25 years and Mr. Buffett has advised the Committee that he would not expect or desire such compensation to increase in the future…

...Mr. Buffett will on occasion utilize Berkshire personnel and/or have Berkshire pay for minor items such as postage or phone calls that are personal. Mr. Buffett reimburses Berkshire for these costs by making an annual payment to Berkshire in an amount that is equal to or greater than the costs that Berkshire has incurred on his behalf.

During 2018, Mr. Buffett reimbursed Berkshire [US]$50,000. Berkshire provides personal and home security services for Mr. Buffett. The cost for these services was approximately [US]$290,000 in 2018. Berkshire’s Board of Directors believe that in light of Mr. Buffett’s critical role as Berkshire’s CEO and given that Mr. Buffett spends a significant amount of his time while at home on Berkshire business matters that such costs represent bona fide business expenses.

None of Berkshire’s named executive officers use Company cars or belong to clubs to which the Company pays dues. It should also be noted that neither Mr. Buffett nor Mr. Munger utilizes corporate-owned aircraft for personal use.”

Buffett and Munger earn their riches predominantly from their ownership of Berkshire shares. As of 6 March 2019, Buffett controlled Berkshire shares that are worth around US$90 billion at the current price; Munger’s stake also makes him a billionaire (around US$1.5 billion). These high ownership stakes give me comfort that their interests are aligned with mine.

Although Buffett and Munger’s philanthropic actions are not directly-related to investing, I think they speak volumes about the characters of the two elder statesmen of business. The actions also inspire me, so I want to include a brief discussion. In 2006, Buffett pledged to donate more than 99% of his wealth to charitable causes during his lifetime or at his death. Since then, Buffett has already given more than US$34.5 billion to charities. Munger, meanwhile, has given hundreds of millions of dollars over the past 30 years toward the building of school facilities.

On capability

On the topic of capability, Berkshire’s track record of growth since 1965 has been nothing short of stunning. More on this soon.

On innovation

For a long time, Buffett was averse to technology stocks because he couldn’t understand them (he first broke the duck by investing in IBM in 2011, and of course Berkshire now has a big stake in Apple). So it’s no surprise that Berkshire is not the first name that comes to mind if we mention the word “innovation.”

But what Berkshire lacks in technological innovation, it makes up for with a unique mindset in business.

Let’s first talk about Buffett’s view toward acquiring companies. I want to discuss this because acquisitions will be one of Berkshire’s key growth drivers in the years ahead. The excerpts below from Berkshire’s 2008 shareholders’ letter are instructive (emphases are mine):

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).

Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.

Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing.

A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.”

I believe that Buffett’s mindset of wanting to be long-term (eternal?) owners when acquiring companies, alone, is a competitive advantage in the private markets that is not easily replicable. Berkshire has walked the talk of being a responsible long-term owner of businesses and implementing decentralised management – these traits have made the conglomerate a preferred buyer when owners of good private family-built businesses are looking to sell. In his 2018 shareholders’ letter, Buffett again emphasised that Berkshire wants to be a long-term owner of the businesses that it acquires:

“You may ask whether an allowance should not also be made for the major tax costs Berkshire would incur if we were to sell certain of our wholly-owned businesses. Forget that thought: It would be foolish for us to sell any of our wonderful companies even if no tax would be payable on its sale. Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.”

Some of you reading this may be wondering, “Is Buffett’s competitive advantage in acquiring companies really so simple? Isn’t that easy to replicate?” My response will be something Munger once said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

There are two main components to Berkshire’s operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there’s high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that’s something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility. Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A proven ability to grow

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire’s 2018 annual report, and it shows the incredible 18.7% annual growth in the company’s book value per share since 1965, the year Buffett assumed control. ‘Nuff said.

*Source: Berkshire Hathaway* *2018 annual report*

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.” So why the focus on Berkshire’s book value per share? That’s because Berkshire’s main assets for many decades were public-listed stocks. Although, it’s worth pointing out that the company’s book value per share is increasingly losing its relevance as a measure of the company’s intrinsic economic worth – Berkshire’s main value now resides in its subsidiaries.

It must also be said that Berkshire’s no slouch when it comes to free cash flow. The table below shows the record of the conglomerate’s annual growth in free cash flow of 11% going back to 2007. I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don’t see any reason to believe that Berkshire’s ability to generate cash from its businesses will change any time soon.

Valuation

In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.”

The four groves Buffett mentioned refers to Berkshire’s (1) insurance operations, (2) non-insurance businesses, (3) ownership stakes in a quartet of companies – Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J – that it shares control with other parties, and (4) treasury bills, cash, and fixed-income investments.

I like to keep things simple in the valuation process, so I’m going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire’s book value per share is losing relevance in being a proxy for the company’s true economic worth, so there’s a contradiction. I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett’s recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is “below Berkshire’s intrinsic value.”

Buffett publicly stated in his 2018 shareholders’ letter that over time, Berkshire is likely “to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.” From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company’s PB ratio was clearly higher than 1.2 and averaging around 1.4.

The risks involved

Succession is the biggest risk I’m watching with Berkshire. Buffett and Munger are both getting on in years – I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler. All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire’s culture.

I am confident in Buffett and Munger’s succession plan. But it remains to be seen whether Berkshire’s dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I’m watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion. For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there’s no upper limit to Mother Nature’s wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

The Good Investors’ conclusion

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability. The conglomerate excels against my investment framework by having (1) the American Tailwind behind its back; (2) a diverse collection of excellent businesses; (3) a robust balance sheet and finances; (4) strong recurring revenues; (5) a great track record of growth; and (6) two brilliant leaders at its helm who have been there for decades – Warren Buffett and Charlie Munger – and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire’s business is in insurance) are two big risks for the conglomerate that I’m watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range.

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.

What Should Frasers Commercial Trust Unitholders Do Now?

Frasers Logistics and Industrial Trust is proposing to acquire Frasers Commercial Trust. Here’s a breakdown on possible scenarios and what actions to take.

Frasers Logistics and Industrial Trust has proposed to acquire Frasers Commercial Trust in a shares plus cash deal. In essence, Frasers Commercial Trust unitholders will receive 1.233 Frasers Logistics and Industrial Trust units and S$0.151 in cash for every unit of Frasers Commercial Trust they own.

In light of the proposed deal, I had previously shared my thoughts on what it means for Frasers Logistics and Industrial Trust’s unitholders. Below are my thoughts on what the merger means for Frasers Commercial Trust’s unitholders.

Scenario 1: The proposed deal goes through

Existing unitholders of Frasers Commercial Trust can accept the offer tabled to them. In exchange, they will receive cash and units of the new REIT. This outcome could be fairly rewarding.

For one, there are reasons to believe that the new REIT can provide solid returns for unitholders. If the deal does go through, Frasers Commercial Trust unitholders will be able to participate in the new REIT’s potential upside.

The new REIT is expected to provide a 6% distribution yield (if you consider the market price at the time of writing of S$1.23 per unit). The enlarged REIT will benefit from a diversified portfolio with the potential to grow its rental income organically.

The deal will also enable Frasers Commercial Trust’s unitholders to cash out a portion of their holdings, due to the cash portion of the acquisition.

Scenario 2: The proposed deal gets rejected

If the deal gets rejected by either party, it will not go through. In that case, Frasers Commercial Trust unitholders get to keep their stake in the existing REIT.

I think the main reason why Frasers Commercial Trust unitholders may reject the deal is that they may not view the purchase price to be high enough. They will also be receiving new units of the enlarged REIT at fairly high prices. Based on current market prices, the new units will be issued at a 29% premium to book value.

Scenario 3: Unitholders can sell their units now

Unitholders of Frasers Commercial Trust can also sell their units before the results of the deal. By selling your units, you can get the cash out immediately and reinvest elsewhere.

This option is for unitholders of Frasers Commercial Trust who do not want to hold on to the units of the newly formed REIT.

This is a reasonable action to take if you have found an investment that is better suited for your portfolio.

Scenario 4: Looking for arbitrage opportunities

The fourth option is to make use of the deal as an arbitrage opportunity.

Although I encourage long-term, buy-and-hold investing, mispricings in the market, especially after a deal has been proposed, can result in the opportunity to make an immediate profit.

To understand how to do this, we must first look at the mechanics of the deal. Frasers Commercial Trust unitholders will be getting 1.233 Frasers Logistics and Industrial Trust units plus 15.1 Singapore cents.

At the time of writing, Frasers Logistics and Industrial Trust shares trade at $1.23 per unit. As a result, the market value of what Frasers Commercial Trust unitholders will receive ($1.667 per unit) is slightly lower than the current market price of $1.67.

As such, investors can instead choose to sell their holdings in Frasers Commercial Trust and purchase Frasers Logistics and Industrial Trust. Of course, they should factor in whether it still makes sense after including any transaction costs (it might not, depending on the broker you use).

The Good Investors’ Conclusion

The proposed acquisition of Frasers Commercial Trust has given its unitholders a lot to think about. Should you simply wait for the deal to pass and enjoy the upside of the enlarged REIT? Or should investors take active steps to achieve a better return by seizing the current arbitrage opportunity? The risk of trying to maximise returns through arbitrage is that the deal falls through.

Additionally, unitholders who do not want a stake in the enlarged REIT can also choose to encash their units now.

Personally, I think trying to make an arbitrage profit is too much effort for too small of an upside (this may change if either REIT’s unit price moves dramatically, which is unlikely as arbitragers will force the price to equilibrate). So for now, I think it is best for Frasers Commercial Trust unitholders to simply wait for the outcome of the deal.

There are potential pros and cons to either outcome. If the deal goes through, exiting Frasers Commercial Trust unitholders can enjoy distribution per unit-accretion, if they reinvest the cash portion of the deal into Frasers Logistics and Industrial Trust. The new trust will also enjoy potential economies of scale, access to cheaper debt, and potentially trade at higher valuations. The downside is that the new units are being issued at a fairly high valuation of 1.29 times book value and the purchase price is fairly low.

Conversely, if the deal falls through, unitholders will continue to hold onto their Frasers Commercial Trust units, which also has a good portfolio of properties, low gearing, and could potentially pay out higher distribution per unit in the future. However, unitholders will miss out on the yield-accretion and the potential to participate in the growth opportunity of a larger, more liquid REIT with access to cheaper debt and equity.

Why Frasers Logistics and Industrial Unitholders Should Be Pleased With The Proposed Merger With Frasers Commercial Trust?

Frasers Logistics and Industrial Trust has proposed a move to acquire Frasers Commercial Trust. Is it good for existing unitholders?

The proposed merger of Frasers Logistics and Industrial Trust and Frasers Commercial Trust is the latest in a flurry of mergers among Singapore REITs this year. But not all mergers are good for shareholders (technically, REIT investors are called unitholders but let’s not split hairs here).

To determine if the proposition is fair to Frasers Logistics and Industrial Trust shareholders, I did a quick analysis of the deal.

[Note: An article discussing what the merger means for Frasers Commercial Trust shareholders was published on 10 December 2019. You can find it here.]

Details of the deal

In essence, Frasers Logistics and Industrial Trust will be absorbing Frasers Commercial Trust. It will pay S$0.151 in cash plus 1.233 new units of Frasers Logistics and Industrial Trust for every Frasers Commercial Trust unit.

In addition, Frasers Logistics and Industrial Trust is proposing to purchase the remaining 50% freehold interest in Farnborough Business Park that is not already owned by Frasers Commercial Trust.

Is Frasers Logistics and Industrial Trust Overpaying?

A share-plus-cash deal can be complicated to process. That’s why I prefer to break it into two parts. First is the issuance of new shares, and second is the purchase of the REIT using existing cash and the capital raised from the fundraising exercise. I will address each of these separately.

Frasers Logistics and Industrial Trust is issuing new shares at a premium to its book value. The new shares (if you consider that they are issued at market prices of $1.23), is 29% higher than Frasers Logistics and Industrial Trust’s current book value per share of S$0.95. Additionally, the new shares are being issued at a trailing annualised dividend yield of 5.8%, which is quite low for a REIT. Because of the relatively high price of the new shares issued, I think the issuance of new shares is positive for existing shareholders of Frasers Logistics and Industrial Trust.
That brings us to the second part of the assessment- the price paid for Frasers Commercial Trust. Based on the current market price of $1.23 for each Frasers Logistics and Industrial Trust share, it is paying $1.66 (1.23 x 1.23+0.151) for each Frasers Commercial Trust share. The implied price is just a 3.1% premium to Frasers Commercial Trust’s book value per share of $1.61. It is also lower than Frasers Commercial Trust’s current market price of $1.68 per share. I think this is a fair purchase price, considering the potential long-term benefits of the deal (more on this below).

Based on the above considerations, I believe the deal will benefit existing unitholders of Frasers Logistics and Industrial Trust.

Immediate impact on distribution per unit and NAV per unit

The new units are being issued at relatively high prices, and the purchase price is just a slight premium to book value. So it is not surprising that the deal is expected to have an immediate positive impact for Frasers Logistics and Industrial Trust. Management expects the acquisition to be accretive to both distribution and book value per unit.

The two charts below illustrate the pro forma accretion to book value and distribution per unit (DPU).

Source: Investor presentation for Frasers Logistics and Industrial Trust merger with Frasers Commercial Trust

Other benefits of the deal

Besides the immediate positive impact on DPU and book value per unit, there are also other potential benefits to the merger:

The enlarged REIT will likely be able to negotiate lower interest rates on its debt in the future
There are potential economies of scale due to the enlarged size of the combined REIT
The bigger portfolio will increase diversification and decrease concentration risk
The new properties absorbed by Frasers Logistics and Industrial Trust have favourable characteristics that could drive growth. For instance, 51.8% of Frasers Commercial Trust’s properties have step-up annual rent escalations of between 3.0% and 4.0%. Also, Alexandra Technopark, one of Frasers Commercial Trust’s six properties, also recently completed an asset enhancement work.

The Good investors’ conclusion

There are many reasons for existing shareholders of Frasers Logistics and Industrial Trust to like the deal. First, the deal will be immediately accretive to both book value and DPU per unit. Second, the enlarged REIT will benefit over the longer-term through economies of scale and diversification. In turn, this should provide the REIT with a longer runway for DPU-growth in the future.

REITs and The Power of Cheap Equity

REITs that have access to cheap equity are more likely to do well over the long term. Here’s why.

I’ve been studying real estate investment trusts (REITs) for some time. One thing that I noticed is that access to cheap equity is an often overlooked but powerful tool for REITs to grow.

“Cheap equity” is a REIT’s ability to raise money at a comparatively low cost.

The benefits of cheap equity

So how does cheap equity arise? First, the investing community needs to be bullish on a REIT. Usually, the REIT will exhibit some of the positive characteristics I tend to look for. The market realises the REIT’s potential and prices its units up. Such REITs end up being priced at a premium to its book value.

The high unit price of the REIT’s units creates an opportunity for it to raise money cheaply. Simply by issuing new units at this high price, the REIT is able to boost its book value per unit and its yield.

A prime example

Let’s consider a recent example. Mapletree Commercial Trust is a REIT that has been trading well above its book value for many years. In October 2019, the REIT decided to make use of its high unit price to raise cheap capital. It announced that it would raise around S$900 million to partially fund the acquisition of a property, Mapletree Business City (Phase2).

The new units were priced at S$2.24 each, well above Mapletree Commercial Trust’s book value per share of S$1.70 (as of October 2019). In addition, the REIT’s new units were issued at a low annualised yield of 4.1%.

There are two key advantages here. First, because the units were priced above book value, the equity fundraising will immediately increase the REIT’s book value per unit. Second, the funding exercise will be distribution per unit-accretive to shareholders as long as the new property purchased has an asset yield of more than 4.1% (or even less if you consider that part of the acquisition will be funded by debt).

A virtuous cycle

The ability to raise money cheapy creates a virtuous cycle for such highly regarded REITs.

Consider the case of Mapletree Commercial Trust:

Investors are bullish on Mapletree Commercial Trust’s prospects and attach a high valuation to it.
The REIT uses the opportunity afforded by its high unit price to issue new shares.
Backed by a strong sponsor, Mapletree Pte Ltd, and positive public sentiment, the REIT is able to raise new funds through an equity fundraising.
As the new units were issued at a high price, the fundraising is immediately-accretive to book value and distribution per unit.
Investors see the growth in DPU and book value per unit and become even more bullish on the REIT and the market pushes the price of the REIT higher. The REIT is now able to raise more capital cheaply.

This whole process creates a virtuous cycle that helps highly-regarded REITs keep on growing.

How investors can benefit

The lesson here is not to be put off by REITs that have relatively high unit prices. A REIT with a high unit price may not offer the best yield but it has the ability to grow much faster than its peers. Having said that, this is by no means a fool-proof scenario.

Investors will also need to pick the REITs that are best able (and willing) to make use of the opportunity afforded to the REIT through its high unit price. One of the key things to look out for is the REIT’s track record of raising equity and whether it has a sponsor with deep pockets.

The REITs that are sponsored by CapitaLand, Mapletree and Frasers have, historically, been some of the best REITs in Singapore’s stock market to own. These three sponsors have been willing to support their REITs through capital injections, even at high valuations.

Knowing this, shrewd investors who spot this trend can capitalise and ride the virtuous upcycle driving well-regarded REITs.

Why I Like This Unique Bank As An Investment Opportunity Now

HDFC Bank from India looks like a really good investment opportunity, given its track record of growth, and strong macroeconomic tailwinds.

I recently appeared in an episode of the Investing Ideas podcast series that is created by my friend, Stanley Lim from Value Invest Asia.

In the episode, I shared why I thought the India-based HDFC Bank looks like an attractive investment opportunity to me. I also prepared a short presentation deck: Download here

The following are some of the points I mentioned in the podcast about HDFC Bank:

The bank has been growing every single year from 1996 to 2019.
The bank is very conservatively managed, with even lower leverage than Singapore’s local banking stalwarts, DBS, OCBC, and UOB.
The bank has a fanatical focus on the customer experience.
India has amazing population tailwinds that many developed economies will envy – the working-age population of the country is expected to increase by 30% from today to 2050. China, in contrast, is expected to have a 20% decline in the working-age population over the same period.

Check out the podcast (and video) below!

“How Can We Avoid Hyflux-Like Disasters”

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.

Why I Own Netflix Shares

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

Netflix is 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.

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.

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 View letter 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.

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.

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.

The Good 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.

“What Should I Do With My Sembcorp Marine Shares That Are In The Red?”

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).

—

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.

Can Factor-Based Investing Outperform The Market?

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.

“Should I Buy Mapletree North Asia Commercial Trust Now?”

Investors are fearful of Mapletree North Asia Commercial Trust right now. Should we buy its shares? The answer is surprisingly complicated.

Yesterday, a wise and kind lady whom Jeremy and I know asked us: “Buying when there is blood on the street is a golden rule in investing. So should I buy Mapletree North Asia Commercial Trust now?”

I responded to her query, and I thought my answer is worth sharing with a wider audience. But first, we need a brief introduction of the stock in question.

The background

Mapletree North Asia Commercial Trust is a REIT (real estate investment trust) that is listed in Singapore’s stock market. It currently has a S$7.7 billion portfolio that holds nine properties across Beijing, Shanghai, Hong Kong, and Japan.

Festival Walk is a retail mall and is the REIT’s only property in Hong Kong. It also happens to be Mapletree North Asia Commercial Trust’s most important property. In the first half of FY19/20 (the fiscal year ending 31 March 2020), Festival Walk accounted for 62% of the REIT’s total net property income.

Hong Kong has been plagued by political and social unrest for months. On 12 November 2019, protestors in the special administrative region caused extensive damage to Festival Walk. Mapletree North Asia Commercial Trust’s share price (technically a unit price, but let’s not split hairs here!) promptly fell 4.9% to S$1.16 the day after. At S$1.16, the REIT’s share price had fallen by nearly 20% from this year’s peak of S$1.43 (after adjusting for dividends) that was reached in July.

For context on Mapletree North Asia Commercial Trust’s sliding share price over the past few months, consider two things.

First, the other REITs under the Mapletree umbrella have seen their share prices rise since Mapletree North Asia Commercial Trust’s share price peaked in July this year – the share prices of Mapletree Industrial Trust, Mapletree Logistics Trust, and Mapletree Commercial Trust have risen by 13%, 5%, and 12%, respectively (all after adjusting for dividends). Second, Mapletree North Asia Commercial Trust’s results for the second quarter of FY19/20 was released on 25 October 2019 and it was decent. Net property income was up 1.3% from a year ago while distribution per unit inched up by 0.6%. And yet, the share price has been falling.

To me, it seems obvious that fears over the unrest in Hong Kong have affected investors’ sentiment towards the REIT.

The response

My answer to the lady’s question is given in whole below (it’s lightly edited for readability, since the original message was sent as a text):

“Buying decisions should always be made in the context of a portfolio. Will a portfolio that already has 50% of its capital invested in stocks that are directly linked to Hong Kong’s economy (not just stocks listed in Hong Kong) need Mapletree North Asia Commercial Trust? I’m not sure. But in a portfolio that has very light exposure to Hong Kong, the picture changes.

Mapletree, as a group, has run all its REITs really well. But most of the public-listed REITs are well-diversified in terms of property-count or geography, or both. Mapletree North Asia Commercial Trust at its listing, and even today, is quite different – it’s very concentrated in geography and property-count. But still, the properties seem to be of high quality, so that’s good.

Buying when there’s blood on the streets makes a lot of sense. But statistics also show that of all stocks ever listed in the US from 1980 to 2014, 40% have fallen by at least 70% from their peak and never recovered. So buying when there’s blood on the streets needs a caveat: That the stock itself is not overvalued, and that the business itself still has a bright future.

Mapletree North Asia Commercial Trust’s valuation looks good, but its future will have to depend on the stability of Hong Kong 5-10 years from now. I’m optimistic about the situation in Hong Kong while recognising the short-term pain. At the same time, I won’t claim to be an expert in international relations or the socio-economic fabric of Hong Kong. So, diversification at the portfolio level will be important.

With all this being said, I think Mapletree North Asia Commercial Trust is interesting with a 2% to 3% weighting in a portfolio that does not already have a high concentration (say 20%?) of companies that do business in Hong Kong.”

Perspectives

I mentioned earlier that Mapletree North Asia Commercial Trust’s valuation looks good and that it owns high-quality properties.

The chart below shows the REIT’s dividend yield and price-to-book (PB) ratio over the last five years. Right now, the PB ratio is near a five-year low, while the dividend yield – which is nearly 7% – looks favourable compared to history.

On the quality of the REIT’s property portfolio, there are two key points to make: First, the portfolio has commanded a high occupancy rate of not less than 98.5% in each of the last six fiscal years; second, the properties in the portfolio have achieved healthy rental reversion rates over the same period.

*Source: Mapletree North Asia Commercial Trust earnings presentation*

Mapletree North Asia Commercial Trust also scores well at some of the other traits that could point us to good REITs:

Growth in gross revenue, net property income, and distribution per unit – The REIT’s net property income has grown in each year from FY14/15 to FY18/19, and has increased by 9.4% per year. Distribution per unit also climbed in each year for the same period, and was up by 4.1% annually.
Low leverage and a strong ability to service interest payments on debt – The REIT has a high leverage ratio. As of 30 September 2019, the leverage ratio is 37.1%, which is only a small distance from the regulatory leverage ratio ceiling of 45%. But its interest cover ratio for the quarter ended 30 September 2019 is 4.2, which is fairly safe.
Favourable lease structures and/or a long track record of growing rent on a per-area basis – At the end of FY18/19, nearly all of Festival Walk’s leases included step-up clauses in base rent. Small portions of the respective leases for the other properties in the REIT’s portfolio also contain step-up clauses. In addition, the REIT has been able to produce strong rental reversions over a multi-year period, as mentioned earlier.

Conclusion

Mapletree North Asia Commercial Trust currently has an attractive valuation in relation to history. It’s also cheaper than many other REITs in Singapore – for example, its sister REITs under the Mapletree group have dividend yields ranging from only 4% to 5%. It also has other attractive traits, such as a strong history of growth, a safe interest cover ratio, and favourable lease structures.

On the other hand, Mapletree North Asia Commercial Trust has high concentration risk since Festival Walk accounts for more than half its revenue. Moreover, Festival Walk’s prospects depend heavily on the stability of Hong Kong’s sociopolitical fabric. I don’t think anyone can be certain about Hong Kong’s future given the current unrest (which seems to have escalated in recent weeks). These increase the risk profile for the REIT in my view.

To balance both sides of the equation on Mapletree North Asia Commercial Trust, I think my point on portfolio-level diversification given in my answer to the lady’s question is critical.

I’m often asked if a certain stock is a good or bad buy. The question is deceptively difficult to answer because it depends on your risk appetite and your investment portfolio’s composition. A stock that makes sense for one portfolio may not make sense for another. Keep this in mind when you’re assessing whether Mapletree North Asia Commercial Trust is suitable for your portfolio.