Cheap Cash-Rich Companies On SGX: Opportunity Or Trap?

Foreword from ShareInvestor

This article “Cheap Cash-Rich Companies On SGX: Opportunity Or Trap?” by Cai Haoxiang was first published in The Business Times on 16 May 2016 and is reproduced in this blog in its entirety.

This week, we examine stocks that have more cash on their balance sheet than their market value

A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit. – Investor Warren Buffett, in 1989 Berkshire Hathaway shareholder letter, beginning a section on his bargain-buy mistakes

The concept is attractive in theory but far harder, even foolhardy, to execute in practice. If you can buy a $1 stock on paper trading at 60 or 70 cents, why not? Such is the thinking behind bargain-hunting, or attempting to buy stocks trading cheaply by various metrics.

The siren song of cheap stocks has lured many a wannabe value investor to his doom. For example, investors wrongly think that just because a stock is trading at a price to book (PB) ratio of less than one, it is cheap and worth buying.

The PB ratio measures how much a company is priced on the market relative to its net assets, or the sum of its assets such as cash and inventories, minus its liabilities such as debts owed.

Surely someone can take over the company and liquidate it for more than what its assets are worth, the thinking goes.

As many people find out too late, stocks can trade below their net asset values because investors – sometimes rightly – do not believe that those values are real. Asset values can be inflated because of accounting quirks, and distorted by buoyant markets and over-optimistic consultants. Sometimes, market circumstances will force the company to spend more and get little back in return, destroying shareholder value in the process.

Yet surely there are some assets that cannot be overstated. Assuming that there is no fraud involved, and after subtracting debt, companies with more cash in the bank than what they are worth on the market should be considered cheap.

Today, we examine such stocks on the Singapore Exchange (SGX) where their net cash (how much they have in the bank after accounting for borrowed money) is actually more than their market capitalisation (how much the company is worth on the market after you multiply their share price by the number of shares issued).

Lenders Flush With Cash

A Bloomberg screen turns up 41 candidates, including some well-known names and plenty of micro-penny and suspended stocks.

But the first two companies that will catch a reader’s eye are finance companies Hong Leong Finance and Sing Investments and Finance.

Hong Leong, long-established and known for lending to small and medium enterprises (SMEs) and smaller developers, has cash of S$1.3 billion excluding statutory deposits, and a market capitalisation of just S$1 billion.

Sing Investments, a smaller but equally established name, has cash excluding statutory deposits of S$310 million and a market capitalisation only slightly more than half of that.

Does having more cash than what the companies are worth mean both companies are extremely undervalued? Not so fast.

Finance companies are regulated differently from banks. Yet they are similar to banks. Their core business is to take in deposits from customers, recorded as liabilities, and lend them out again, in interest-generating loans recorded as assets.

In an economic downturn, the biggest risk is that these loan assets can go bad, meaning that customers cannot repay their interest payments or even the bulk of the principal borrowed.

Now, finance companies generally carry out secured lending, meaning that there is some collateral they can fall back on.

But in the worst case scenario, the collateral – usually property – might not be easily sold. Or it will be worth less than what the company thought it was worth. In this case, the company will have to write the loan off. Its asset values will take a hit.

In that scenario, the company will need plenty of cash to reassure investors that their money is safe. Both banks and finance companies are subject to laws on having to hold a considerable portion of their loan book, or of their deposits, in cash and safe securities such as government bonds. Asked about the purpose of cash on the balance sheet, a Hong Leong spokesman said that a stable cash balance was needed to meet contractual obligations and regulatory requirements.

Lenders need a cash buffer. So not all of the cash on a finance company’s balance sheet can be deployed to, say, give a big dividend to shareholders.

Banks More Attractive, But Take Different Risks

When analysed using the PB metric, both banks and finance companies might look attractive on absolute terms. They are all trading below their book values.

Yet as mentioned above, investors do not think that their book values sufficiently reflect economic reality.

On a relative basis, finance companies are valued even more cheaply than banks (see chart).

Again, that might not spell an opportunity. It is striking how on a relative basis, banks have persistently been valued more as a proportion of their net assets, than finance companies.

Singapore’s three finance companies – the third being another long-established name, Singapura Finance – have not even traded above book since 2009. This is even while the three big banks traded anywhere from 1.2 to 1.7 times book.

Why is there such a gap? One explanation is that finance companies, forced to compete with the big three banks for deposits, have to settle for lower net interest margins (NIM). They have to offer savers better deposit rates, while giving borrowers cheaper loans. This eats into profits. A bank like DBS, by contrast, has so much “sticky” deposits from Singaporeans, especially through POSB, that it can get away with paying a paltry rate on them.

The NIM refers to the difference between the yield that banks earn on collecting interest payments, and the yield that they need to pay out for their deposits. Hong Leong, for instance, has a NIM of 1.3 per cent in 2015. The DBS NIM, by contrast, is at 1.77 per cent.

Banks also enjoy other ways of making money that finance companies do not. For instance, they can lend out money without the need to demand collateral from the borrower, in what is known as unsecured lending. The consumer unsecured lending business is conducted through credit cards. Finance companies can only practice a very limited form of unsecured lending.

Banks can also pursue businesses such as offering payments and deposits related to foreign currencies.

As a result, finance companies tend to be less profitable than banks. We can see this through the chart above comparing the returns on equity (ROE) of the two different sectors. While banks have maintained their ROEs in the low teens, finance companies have seen their ROEs decline in recent years from the high single-digits to under 5 per cent.

Finally, it is also worth looking at the kind of loans that both finance companies are exposed to.

While banks like DBS lend to established corporates, finance companies cater to SMEs with potentially different risk characteristics.

Thus on a net cash to market cap basis, finance companies Hong Leong and Sing Investments might look attractive.

On a PB basis, their valuations look less extraordinary. They are less profitable than the big three banks. And in a slowing economy, they would also be reluctant to lend.

Nevertheless, the amount of cash that finance companies hold and their track record in surviving past crises might mean that investors and depositors can sleep soundly at night.

The issue facing the lending industry is a cyclical one. If and when the world works out its overcapacity and demand problems, animal spirits will return. Entrepreneurs will want to borrow more to expand, and banks and finance companies will be more willing to lend to them again. Then, valuations for the entire sector can rise.

China Minzhong

Another company that appears on this screen is vegetable processor China Minzhong, though its latest numbers show that its market cap is above its net cash.

Some might remember the company for being attacked by a short-seller in 2013 before major shareholder PT Indofood Sukses Makmur, an Indonesian food giant, rode in to rescue investors with a general offer of S$1.12 a share. Indofood now owns 83 per cent.

At end-2014, China Minzhong said that a company linked to its executive chairman Lin Guo Rong, CMZ BVI was planning to buy a 53 per cent stake from Indofood at S$1.20 a share.

However, after one-and-a-half years, CMZ BVI is still trying to finalise funding arrangement terms with financiers.

China Minzhong has a substantial cash balance of some 4.3 billion yuan (S$900 million) on its balance sheet at end-March, versus close to two billion yuan of debt.

Net cash of 2.4 billion yuan, set against its market capitalisation of three billion yuan, means that 80 cents out of every dollar in China Minzhong’s share price is cash. The business is also still profitable.

So here is a stock that has an acquisition catalyst, seems profitable, and has a large cash balance.

Yet investors remain suspicious of the company’s balance sheet, probably because of its Chinese origins.

Kingboard Copper

Our fourth example is Kingboard Copper Foil Holdings.

What is at first glance curious is that the company has no debt and a persistent, extraordinarily large cash pile for many years now.

As at end-March, Kingboard Copper has HK$1.45 billion (S$256 million) as cash on its books, or 35 Singapore cents a share.

But it is trading at around 27 cents, having rallied from around 20 cents in the past year.

Why is there a rally now? The tale takes some explaining.

There has been a long-running dispute between the Kingboard management and minority shareholders dating back to 2011. Before September 2011, the company made copper foil to supply its parent company, Hong Kong-listed Kingboard Chemical Holdings.

Yet there were some allegations that Kingboard was selling copper foil to its parent at a discount. That year, at the company’s annual general meeting, unhappiness boiled over. Minorities voted down a mandate for the group to enter into interested person transactions (IPT) with its parent.

The non-renewal of the IPT mandate crippled much of the group’s core business.

To fight back, management entered into a licensing agreement with a company, Harvest Resource Management, to continue its copper foil business in some form. Since September 2011, Kingboard Copper’s income would come from sales of a resin used to make reinforced glass, as well as the licensing income from its new arrangement.

The largest minority shareholder, Annuity & Re Life Limited, struck back. It sued Kingboard for conducting its business in a manner “oppressive or unfairly prejudicial” to its interests through “preferential transfer pricing”.

Now, what got some investors excited recently was that the saga seemed to be drawing to a close.

A Bermuda court ruled late last year that Kingsboard should initiate negotiations to persuade minorities to approve the IPT. The company has filed an appeal against this judgment.

What was interesting was the possibility that the majority shareholders might be ordered to buy back shares from minorities “at a market price to be determined with reference to when the prejudicial effect of the licence agreement began”, according to a company disclosure on the advice of its Bermuda lawyers.

(For what it is worth, by the time the licence agreement began, the share price was around 20 cents, having fallen from over 35 cents.)

Both sides are submitting their valuations. But shareholders might have to hold their breath a bit longer as the appeal by the company on the court’s judgment, which takes place next year, could affect the process.

Creative Technology

Another well-known name in the screen is Creative Technology, the erstwhile homegrown global technology giant of Singapore. It has no debt and some US$97 million in cash, or S$1.89 a share.

It is languishing at around S$1 a share. What gives?

The company, known for its PC Sound Blaster cards, has fallen out of the radar of most investors.

It is fighting a number of costly legal battles for patent infringements.

Occasionally, it wins some. For instance, it bagged US$12.5 million in its results for the quarter ended March 31, 2016, from settling one lawsuit. By contrast, its entire quarterly revenue was US$18.5 million.

Lawsuit wins might keep Creative in the black for now, but investors are still waiting for the right product that will bring the company to global dominance again.

In the meantime, the stock looks pretty cheap.

Are They Cigar Butts?

These are just five examples. But before jumping at the opportunity, investors should do well to remember Warren Buffett’s dictum on cigar butts.

These are unattractive businesses trading at such a low price that “there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible”, he said.

He ultimately concluded that buying such businesses was foolish.

For one thing, there could be more problems than investors bargained for. “Never is there just one cockroach in the kitchen,” he said.

Moreover, he said, the low returns of such businesses might negate the gains from the investor’s bargain purchase, such that long-term returns end up being low.

Yet given the above companies with cash balances larger than their market capitalisation, there could be specific opportunities.

Cash is king, after all. But in the hands of the wrong people, and in the wrong types of businesses, cash will be wasted.