For Singapore Stocks, Winter Has Come

Foreword from ShareInvestor

This article “For Singapore Stocks, Winter Has Come” by Cai HaoXiang was first published in The Straits Times on 28 Dec 2015 and is reproduced in this blog in its entirety.

It is time for intrepid investors to start researching value stocks

There is a dangerous myth, perpetuated at investing seminars, that investing is easy. By following some rules, you’re bound to make some money, they say.

“Hold stocks in the long term, they will always go up,” goes a common saying.

“Don’t buy a stock with a price to earnings (PE) ratio above 12,” I heard once.

“Buy a stock with a track record of earnings,” goes another piece of advice.

So there is a blue chip stock trading at a PE ratio of 6 and a dividend yield of over 7 per cent, with a long track record of profits.

Do you buy it?

This stock is Keppel Corp, one of Singapore’s most well-known conglomerates. The last time it made a full-year loss, according to Bloomberg, was in 1998.

Yet if you thought Keppel was cheap at the beginning of the year, when it fell to a low of around S$8 and the dividend yield was over 6 per cent, you’d have another think coming, given that it fell to near S$6 at one point this month.

For some reason, regular investors seem to misunderstand the stock, and some fundamentals of investing.

One told me it was an infrastructure company, and therefore it will be stable.

Another said she is buying it because of its dividends.

Yet another liked how the company has work stretching out over the next five years.

But Keppel is not an infrastructure company, earnings wise. It is an offshore and marine company with an infrastructure bit attached, and after the Keppel Land privatisation, more of a property bit attached.

It makes big investments to try to reap big rewards. Its dividends are not necessarily backed by strong and regular free cash flow. Putting aside the question of whether dividends are sustainable, the share price fall this year has shown that the value of your stock can decline by far more than the dividends you expect to get from it.

What’s the point of putting aside S$100 in the hope of getting S$7 back, when your S$100 is now S$70 and could be there for many years to come?

Going into 2016, the biggest question the conglomerate will face is what is going to happen to billions of dollars worth of rigs which are completed or nearing completion, which revenue and profits might have been recognised for, but for which cash payments have not yet come in.

Customers who have ordered the rigs years ago, when oil prices were high, are now unable to find a use for them. So they are asking if the rigs can be delivered later.

A jack-up rig used for oil drilling in shallower waters can cost S$300 million, and 80 per cent of the price – S$240 million – will typically not be paid until delivery.

A CIMB report on Dec 3 noted that seven of these rigs are at risk of deferment or even order cancellation.

Crunching the numbers, around S$1.7 billion of cash might come in later than expected, or worse, not come in at all. If an order cancellation happens, Keppel might be stuck with an asset that it will not be able to sell that easily anytime soon. That is cash that could have paid for two years’ worth of dividends, with Keppel’s dividend payouts at around S$800 million a year.

Future cash streams are also at risk. There are five semisubmersible rigs for deepwater oil drilling worth S$5.2 billion due to be delivered to Brazil company Sete Brasil from 2015-19, and two projects for Brazil oil giant Petrobras worth S$1.2 billion for delivery in 2016-17.

Sete Brasil needs to sort out how it will pay banks debt it owed them. The loan repayment deadline for money owed to five Brazilian banks has been extended into next year. Only when that is sorted out can Keppel work out the delivery of some semis: one which was substantially completed by October and another being two-thirds completed.

The best case scenario is that money will come in later than expected.

The worst case scenario is that oil prices stay at these levels for a few years or more, contracts get cancelled, no new orders come in, and existing assets are impaired.

Keppel is not likely to go bankrupt given its Temasek backing, but there is a question mark over whether the dividends that shareholders have become used to are sustainable.

Without understanding its main offshore and marine business, and the boom and bust dynamics behind it, retail investors should have no business buying Keppel stock.

Neither can simple conclusions be made by looking at financial ratios like PE, the price to book ratio, or the dividend yield.

By themselves, they don’t mean anything unless broader business dynamics behind them are understood.

And there are market dynamics to contend with, where attempted valuations using financial ratios and rules of thumb go out of the window in a downturn.

Fire Or Ice

The end of the world, when it came during the 2008-9 global financial crisis, was fiery.

The Straits Times Index (STI) was at 3,000 points in March 2008, bottomed at 1,456.95 points in March 2009 and promptly recovered to around 2,700 points half a year later.

In Singapore, the government rolled out substantial measures to prevent unemployment. The recession came and went.

This time, at the end of 2015, the end of the world looks icy, more like a slow freeze than a quick burn, ever since the penny stock crash of 2013 caused liquidity to disappear.

Oil has crashed. And there has been a stock market crash here, but only in certain parts of the market like commodities or offshore and marine stocks. And even that crash took a year to play out.

Singapore might have performed terribly among developed market stocks, being roughly 15 per cent down. But there’s no widespread panic like in 2009, when almost everything could be bought for a song.

Singapore’s big three banks are dragged down by bad debt fears due to the oil price crash and the slowing regional economy. But they are not trading at crisis levels.

Other stocks are still doing well. Raffles Medical Group is trading at over 30 times earnings. Supermarket chain Sheng Siong is trading at over 20 times earnings. Reliable transport stock ComfortDelGro is also riding high at over 20 times earnings on hopes of bus reforms making the company asset-light.

Telco stalwart Singtel is operating under a cloud of rising interest rates, but is still trading at 15 times earnings. It’s not expensive, for sure, but if earnings are not going to grow, a valuation in the mid-teens is not attractive.

What’s a Singapore investor to do in this environment?

The first thing is still to look through the stocks listed on the STI and start really understanding their businesses.

These stocks are still, broadly speaking, Singapore’s best businesses. They can be complicated. But investors have to try to understand them, or they will be caught out. Keppel could be worth a buy at some point. But the investor has to figure out how much its property segment is worth, and how much its offshore and marine segment is worth.

The second thing investors have to do is to understand how much they do not know, and how much analysts do not know. An attitude of humility and scepticism is necessary if one is to survive in the markets over many business cycles.

Many people, including myself, underestimate how devastating a business downturn can be, and how much prices can fall in response. At the end of 2014, after an oil price crash, then-DMG Research targeted 3,720 points for the STI. UOB Kay Hian targeted 3,600 points. Many hoped oil prices will rebound in the second half of 2015. Instead, they fell much more.

Now, at the end of 2015, analysts hope the government will loosen some cooling measures at the end of 2016, which will cause property stocks to rebound.

The macroeconomic environment, however, is dim. Interest rates are due to rise slowly. Yet their rise will drag down valuations of all assets, all things being equal. This is because if you can put money for a higher reward in a low-risk bank account, you will require a higher interest rate to entice you to invest in riskier assets. Those higher discount rates that investors use will lead to lower valuations.

In a long winter scenario, markets could go two ways. One is that the winter will get even harsher. Earnings, and then prices, drift down slowly and eventually discourage investors from participating in the market altogether.

This was what happened to China’s stock market from 2010 to 2014. One fervently hopes that does not happen here.

In this situation, you would invest thinking 10 times earnings is cheap. But business is so bad that earnings eventually halve and your stock is suddenly priced at 20 times earnings. The market then reprices that stock down to 15 times, 10 times, and even 5 times earnings. Maybe earnings drop further. Faced with large losses of 50 per cent or more, most investors give up on stocks and liquidity dries up.

The other possibility is that both valuations that investors ascribe to stocks, and company profits, have bottomed, but remain stagnant for a long time. This isn’t a bad thing, because you can keep investing in hopefully good assets while waiting for sentiment to pick up again.

You would want to look for evidence that the company can cut costs faster than its revenue declines.

If the business cycle turns and companies start making progressively higher profits, value will go up.

Given how sentiment on Singapore stocks is quite bad, it is time for the intrepid investor to begin the hunt.

Watch Out For Value Traps

One possible place to look is the realm of companies that investors have such negative views on, that they price them at least 30 per cent below their net assets. Some are also trading at low earnings multiples.

The low price to book ratio is just a starting point. The ratio cannot be trusted because the book value of assets is often overstated.

Many of these stocks tend to be property related. This is because investors have a healthy, and justified distrust of the valuations assigned to the buildings and land these companies hold. In good times, assets can get revalued up. Investors holding real estate investment trusts (Reits) can check out how much their properties have been revalued upwards in recent years.

Quite a number of “cheap” companies are in the offshore and marine space. Here, the fear is contract cancellation, which is disturbingly happening with increasing frequency. Some of these companies face bankruptcy if the ships they own cannot find work, or if the ships they have built cannot get delivered. This leaves them unable to generate the cashflows needed to repay debt. Assets, valued in good times, may not be worth what you think they are.

Tread carefully in this space.

There are no easy answers. Among the stocks highlighted are also value traps. These are companies that investors buy thinking they are cheap, but they are actually expensive due to overstated asset values.

Investors also need to know that Singapore’s market is rather small, where the vast majority of companies make annual revenues of at most a few hundred million dollars. If their profit margins are low, say 5 per cent, shareholders will get S$20-30 million in earnings a year. Their market capitalisations are also mostly below S$1 billion. We can define these companies as small-capitalisation stocks, even small and medium-sized enterprises (SMEs).

If you want a reasonable assurance that the business is solid, you should be looking at global companies making at least hundreds of millions in net profit or more a year. Many of these companies trade on other exchanges.

By contrast, investing in SMEs can be high risk. Much depends on the founder. There are often corporate governance issues. Banks might not support them as much when they fall on hard times.

There is a misconception that high risk equates to high reward. But if risky stocks gave investors a high likelihood of making money, they wouldn’t be risky any more. What high risk investing in SMEs gives you is a high chance of losing whatever you have invested if the business tanks and never recovers.

I deliberately avoided including a stock’s dividend yield in the table. Dividend yields are a time-tested trap.

Remember Rickmers Maritime Trust? Before it suspended its dividend payments in November, it had been, for the longest time in recent years, paid out around 3 Singapore cents in dividends while its share price hovered near 30 cents. This gave them a dividend yield of 10 per cent.

Around June, I was talking to an experienced investor who runs a fund. He was wondering whether the stock was an opportunity. I hope he didn’t buy. Rickmers is now trading at 10 cents, down 66 per cent since June. No dividend payout would have saved the Rickmers yield investor.

I don’t know whether 2016 will see a rebound in the market. I don’t know if the market is fairly valued. But I do sense sentiment is on the lower half of the scale, and the market has corrected, and that people always overreact. I am holding on to less cash, and a larger allocation of stocks.

To survive winter, investors have a lot of work to do. As the saying goes, there is no such thing as bad weather, just bad clothing.