The Nuclear Saga Continues

After 3 weeks of intense battling with the nuclear reactors, our heros at Fukushima aren't really winning. In fact the situation is going from bad to worse. Radioactive substance is found in almost 100 different types of food, seawater is contaminated, tap water in Tokyo cannot be drunk, the area around Fukushima would probably be unlivable for the next 20 to 30 years.

The final outcome might be similar to Chernobyl, ie pouring a few hundred thousand tonnes of concrete to entomb the reactors. Even that is just a temporary fix. Ukraine now needs financing for a permanent structure to seal Chernobyl and has difficulty getting it.

The key company in question, Tokyo Electric Power or Tepco, meanwhile fell 80% over the last 3 weeks and it looks like it's going to zero. The reasons: cleanup, decommission, compensation costs is likely to wipe out its entire equity. Even bondholders might need to bear the brunt.

Tepco is also a sad case of becoming a political sacrificial lamb. Its public track record has been dismal. The co was run by ex-bureaucrats "descending from heaven", who are there to enjoy retirement rather than to run a company. Experts warned the company about inadequate measures, both Fukushima and also another nuclear plant that was affected in the past, but were brushed aside. And of course, the most unforgivable mistake: mis-reporting the radiation levels! Man, wake up your idea!

So while the earthquake, theoretically speaking, was a natural disaster and hence Tepco should not be asked to pay for compensation to the farmers and the fishermen, the Japanese govt would likely let it shoulder the bulk of the cost. Not to mention, the govt itself is really tight on budget. It cut the child allowance to raise money for the handling this disaster. Sorry kids, no milk for you until you are 18, and we have to send you to study in University of Heidelberg, where education is free.

But even without the compensation costs, the other big ticket stuff like decommission of the plants, replacement fuel cost and other nitty gritty are likely to put a huge dent into the equity. Assuming the market is correct, these should add up to like USD 20 plus billion, roughly equivalent to the fall in value of its market cap.

For the retail shareholders who held this stock for its dividend, tough luck. Suddenly, almost the entire capital is gone! I guess this truly highlights the risk of equity investing, or rather, any kind of investing. Things can go really, REALLY wrong! Hence it's always prudent to just put money you can afford to lose.

The bigger lesson: diversify. Make some kind of rule, like never put more than x% of your net worth into one investment or something. While it will be difficult to hit the jackpot, at least, if something like Tepco happens, the kids still can have their milk or go to a school of their choice.

With the nuclear story going down the chute, the smart money is pouring into LNG, oil and coal. This is the sad outcome: the world will become a hotter place. Well if we get to tap on more of LNG, it's not so bad bcos it's still the less carbon intensive among the three.

But LNG requires huge infrastructure: the gas pipes, the LNG tankers, the terminals to store them, liquification and gasification equipment etc. It would take some time for Asia and some of the emerging countries to build this up. Meanwhile the LNG stocks have gone to the moon in recent days. Check out Woodside Petroleum of Australia.

I guess in time to come, the world would realize that it still needs nuclear energy. Nothing is as cheap, reliable and scalable in a big way. Hopefully we won't have to wait 25 years after Fukushima. Or we would be wearing a lot more dry-tech T-shirts and using a lot more Ice-Type face wipes!

A Long Nuclear Winter for Nuclear Stocks

The nuclear industry was one of the sexiest story for 2010. With the BRIC's rising fast, the world's hunger for energy looks insatiable. Renewable energy, bio-fuel, oil sands, nuclear were the buzz words. Nuclear was special though. It's clean, cheap and scalable in a big way. It can contribute 25% to the global grid if the world's govt put in the effort. Some developed countries are at that ratio. France, the No.1 nuclear supporter, is at 70%. Sadly for the world, today it's still a miserable 14%.

Undoubtedly it will go down below 10% in the next 10 to 20 yrs, thanks to what had transpired at Fukushima. Almost every country with major nuclear plans started talking about holding back, including the US, France, UK and India. Germany, a country that had never believed in nuclear after Chernobyl went a step further to expedite the decommission of existing plants that are deemed too old. Finally, a couple of days ago, China the last man standing, decided to review its nuclear power plans.

As for nuclear stocks, which were darlings just a couple of months ago, became dogs. On average, they were down 30%. Some of those most badly affected by Fukushima were down 40-50%. Some are now trading at 10x PE multiple, as compared to at least 15-20x when the story was hot.

I guess the lesson learnt here is one on valuation vs story: never pay for a sexy story. Just like Buffett, he is known never to pay for growth. Value investors should follow Jerry Maguire. Show me the money first. Buffett pays a good multiple for a good franchise, with strong track record but not for concept, nor sexy growth. Well he did buy BYD, but he paid HK$8 for HK$0.60-0.80 earnings ie 10-13x at that time. That's not so bad. You have to give it to him lah.

If you have a hunch for a good story e.g. nuclear or smart grid or cure for cancer, look for beneficiaries but also look at the multiple. If it's 10x, well that's a no brainer, buy. If it's 15x, then you need to ask, okay, is the growth going to be more than 15% and how sustainable is that, 2 yrs or 5 yrs or 10 yrs? If it's 20x, then forget it, even if it makes the growth, you have paid $1 for $1 worth of goods, there is no additional upside.

The nuclear stocks were just that. trading at high teens, the growth was factored in and when Fukushima came about, they cracked, like a Singaporean having a hard time in Mumbai, after drinking its water.

So now is it time to buy nuclear stocks? Sadly, I don't know. Some of them are now 10x, yes that is cheap, but earnings might decline going forward. After Chernobyl, we know the industry is not going come back for a long time. Last count, it's about 25 years. It's a long nuclear winter ahead. Maybe this time we are in a different era, we are really short of energy. Maybe the governments will finally get rational as they know that without nuclear, we are going to make the Arabs very rich and Qaddafi very powerful and that is not good. So they push ahead with their plans for more nuclear power. Well, that is wishful thinking perhaps.

As a last note, it is worth highlighting that for all the unfortunate souls who suffered or died from the effects of nuclear radiation since nuclear came about, the worst impact was not the pain nor the fear of dying. It was actually discrimination, by "normal" people. Imagine telling someone you just met that you are from Chernobyl in 1986 or Hiroshima in 1945. Next thing you know, they are ten feet away and running. Shunned by society, these victims suffered the most at the heart, not the body.

I hate reducing people to numbers, but it tells the story really well. So this is the punchline: The number of victims due to nuclear accidents since the birth of nuclear energy is less than 10,000 in all. In comparison, 20,000 coal miners dying every year. Not to mention the many millions more who get affected by polluted air and water. So should we be shutting down coal mines or nuclear plants?

For a solution that can solve a huge part of Earth's energy problem, Chernobyl and now Fukushima does really have a disproportionately huge negative impact far beyond what the media monkeys can imagine.

Anyhows, for now, let's just hope that our 50 heros at Fukushima can save the world this weekend!

Blue Ocean Strategy

This is the name of a popular book published about 5 years ago that helped improve how the top management of many companies think and how they should come out with strategies to help their company grow.

I started reading this year (yeah, I know...) and found some intriguing ideas that I thought I should share it here. Here are some of those that would really help investors when they do some analysis on companies.

1. Blue Ocean Strategy simply refers to innovations that companies come out with that separate them from the competition. The strategies centre on creating uncontested market space, new demands which was non-existent in the current world (red ocean). This can be done by reconstructing market boundaries by focusing on value-add to end users, combining virtues of different but competing industries or simply creating a new product. The strategy also involve reducing current cost structure while creating new demand thereby helping grow both the topline and the bottom line at the same time.

Some well-known examples of Blue Ocean Strategies would be:

Apple's iPhone (redefining value-add to users)
Apple's iPad (new product, new market)
Nintendo's Wii (expansion of gaming to non-core gamers)
Cirque du Soleil (combining virtue of circus and art)
NetJets (value add of both private jet and commercial airline)
Berries (focusing on fun-to-learn Chinese for English-speaking kids)

2. According to the book, blue ocean strategies are usually not created by new players in the market, nor by technology, nor by big companies. Most companies never continuously come up with blue ocean strategies. The unit of analysis, then, is not a company, nor industry, nor change in technology. The most appropriate unit of analysis is therefore the strategies.

3. Blue Ocean ultimately becomes Red Ocean as competitors catch up. Fat profit margins eventually go down and the whole industry succumb to volume and price competition. ie pursuing profit increase by growing the revenue (usually targeting only single digit improvement) and/or reducing price (by reducing cost and passing on this benefit to clients).

For investors, we should always try to look for companies that are going into wonderful Blue Oceans which they are creating. Companies with strategies venturing in the Blue Ocean ultimately enjoy huge profit growth that are not factored in by the markets. However it may not be easy identifying such companies, hence it is still important to look at the valuation of the stock while betting on Blue Ocean.

This means that as value investors, we cannot buy a Blue Ocean company when the PE is 20x. It goes against the grain of value investing. What if the Blue Ocean turns out to be only a 1 yr phenomenon, then we are pretty screwed bcos when we bought at 20x, and the market is usually discounting a few good years ahead. A good investment strategy would probably be buying into a cheap stock with potential to unlock a Blue Ocean.

However we must also be cognizant that Blue Oceans will ultimately become Red Oceans. Blue Ocean stocks probably see their intrinsic value explodes in the first few years but later plateau out or even decline. This is in contrast with the fantastic Dividend Aristocrats whereby the intrinsic value simply rises over time usually for decades.

Colgate-Palmolive - Part 4

Finally, we have here a quick cheatsheet of Colgate's financials.

Basically, it's a company earning USD 4bn on a revenue base of USD 16bn every year and we can expect this to grow maybe 13-15% for the next few years. This growth factors in all we have talked about, including P&G's entrance, GDP growth etc.

Toothpaste is a business that doesn't need a lot of capex, so basically free cash flow is used to pay shareholders. It's free cash flow is about USD 2.4bn, and the FCF yield is 6%.

The interesting part about Colgate's financials would be its balance sheet. Some would argue that it's not exactly great. Debt at USD 3.4bn is greater than its equity of USD 2.8bn. So isn't this risky?

My take is that the management has basically optimized the balance sheet to the hilt. Why is the equity so low? If you notice, equity at USD 2.8bn is the same as a single year's net profit.

This implies that the co. has been paying back equity to its investors. Bcos the business doesn't need money to grow. Whatever excess money made is paid back to shareholders. Although dividend is 3%, Free cashflow yield is actually 6%, I am guessing that the other 3% is used to buy back shares.

And the debt of USD 3.4bn can be easily paid back in less than 2 yrs, using its free cashflow.

However, having analyzed all these, I must admit Colgate is not cheap. PE is 13x two years out, while growth is also roughly 13%. Looking at other measures, EV/EBITDA is a good 10x. This stock is simply trading at its intrinsic value.

The bet here is that the intrinsic value will grow over time. From its track record, it doubles every 8 years or so. Given its current outlook, with growth from emerging markets and some margin improvement, it might take a little shorter than that.

So buy Colgate-Palmolive, get that 3% dividend and see it double to 6% in 6 years and double again to 12% in 12 years! That's a Dividend Aristocrat for you.

Colgate-Palmolive - Part 3

Every stock has its risks and here we talk about Colgate's.

Colgate's biggest risk comes from its competitor - P&G. This company is the nemesis of Colgate, like Jedi vs Sith, Windows vs Mac, Man U vs Liverpool. You get the idea!

P&G has 24% of the oral care market, just a tad smaller than Colgate's 26%. P&G owns Crest - the other big toothpaste brand in US and some other parts of the world (but not in Singapore) and Oral B, the toothbrush specialist.

As we can deduce from our own personal experiences with these brands, P&G probably has a bigger market share in the not-so-profitable toothbrush and other oral products (like floss, denture solution, rinse etc) and a smaller share in toothpaste, where Colgate is really the gorilla here.

Now P&G has been trying to break Colgate's dominance in toothpaste, hence they are been aggressively pricing their products in various important markets. They are really pushing toothpastes of Crest and Oral B into the emerging markets and the biggest market - the US.

This perhaps explained the weakness in Colgate's earnings and stock performance over the past 12 to 18 mths. P&G had some moderate success and Colgate's sales growth in emerging markets indeed slowed in the recent quarters.

With risks in investment thesis, it is also usual practice to come out with mitigating factors, which would help dilute the risks. So for P&G, I guess the mitigating factor would be that the situation would probably be temporary.

This is bcos once P&G reach a optimal market share where it enjoys economies of scale as well as optimal profitability, it doesn't make sense to cut prices to gain volume any further bcos the marginal profit goes down significantly.

Let's rationally thinking about this. In a market where 80% of people uses Colgate (like Brazil or Singapore), there are probably some people who would switch to P&G bcos of price. So we can expect Colgate's share to fall. But after it falls to 60%, ie P&G now has 40% of the market, does it make further sense to throw a ton of money into advertising, sales rebate to get shelve space, and to further price cuts to gain the additional 10%?

Toothpaste is a very personal choice, there would be a group who would never switch from Colgate bcos they like the taste, or the colour or whatever. So it gets harder and harder to get more share.

Of course, P&G also risks Colgate's retaliation. Colgate has lower manufacturing costs bcos of its bigger scale and its first mover advantage. Colgate's local factories are probably built years ago, fully depreciated with more experience staff and sales people. If Colgate embarks on a price war, P&G will lose.

Hence it is likely that P&G would stop cutting prices once it has gained some share and some loyal customers. P&G stands to gain more by maintaining prices, improving margins and just enjoying the organic growth of the market. As the market is growing rapidly, I believe there is room to accomodate 2 players. This means that Colgate would not get to same spectacular growth it enjoyed bcos of P&G's entrance but it's still respectable growth in a great business in the right geographical regions.

As a last note, in a industry where there are only a few players, it make sense to maintain some price discipline such that all the players can make good margins. This is something akin to the Prisoners' Dilemma that we talked about. Both players stand to gain if they cooperate rather than fight.

Colgate-Palmolive - Part 2

Colgate is very big in toothpaste. This is something that is well-known but yet underrated. When I tell people Darlie also belongs to Colgate, most people are pleasantly surprised.

But what really surprised me was when I went down to my local supermarket and saw that the toothpaste segment basically sells just these 2 brands. I mean, Colgate and Darlie dominate the shelves! There are a few tubes of Sensodyne (by GSK), which is now competing with Colgate's own Sensitive Relief Pro. And there is kids' toothpaste. That's it. The rest is all Colgate.

Here's Colgate's market share in some of the world's biggest markets.

Australia 69%
Brazil 67%
Chile 33%
China 33%
Mexico 80%
Russia 33%
Singapore 80% (my personal guess)
UK 47%
US 35%

Isn't this co. amazing? This firm basically dictate what human beings should use when they brush their teeth.

Why can Colgate exert such dominance?

1. Distribution

Colgate is obviously very strong here, it is already distributing toothpaste in the most remote part of the world when people are talking about BRICs. Next time you visit some of our neighbours like Myanmar or Cambodia, take note of the brand of toothpaste they use!

2. Taste

Again, I think people simply don't like new tastes when brushing their teeth, hence they will keep buying the same brand unless prices are raised by 300% or something.

3. Brand

This is something we talked about countless times. When asked to think about toothpaste, what comes to mind? Colgate's mindshare simply dominates.

So there is little threat that things will change in the next few years. Colgate will continue to dominate the markets and grow. Given its high market share in a few regions, it's OPM is also exceptionally high in these regions, at 30% or more. So as these region gets bigger we can expect marginal improvement in the firm's overall blended OPM. But not much, maybe from 25% to 28% or so, over a few years.

Next post - Risks!

Colgate-Palmolive - Part 1

There should always be an investment thesis behind every investment. An investment thesis is a statement to describe in a few words why you bought the stock.

The investment thesis for Colgate would be something like this:

Colgate-Palmolive is the biggest player in the oral care industry with a dominant market share in toothpaste globally. Colgate enjoys the stable growth of the consumer staples sector but has significant exposure to the growing emerging markets (Latam and Asia). Earnings is likely to grow at double digit for the next 3 to 5 years.

After writing the investment thesis, it is usual practice to put down a few positives, risks, valuation, snapshot of the financials and other relevant details.

First let's look at Colgate's geographical breakdown

As you can see, most of Colgate's profits are coming from outside developed markets (US and Europe). There is a segment called Pet Nutrition, although it's probably exposed to developed markets, it's a growing segment with a respectable 15-20% growth. So just roughly calculating, around 65 to 70% of Colgate's business is actually growing fast, ie double digit growth. From there, we can then think of the overall co. blended growth, which would be roughly 8-10% at the topline or revenue level.

At the operating level, margin is at a high 25%. Colgate is a very well-run firm, it's operating margin or OPM has been expanding for the last 7-8 years. However we cannot assume that this would go on indefinitely, maybe 28% would be a peak. There are a few supporting factors:

(a) Emerging markets has higher margins
(b) There is some success launch in high end toothbrushes
(c) Colgate has come up with toothpaste for sensitive teeth, which is grabbing share in developed markets

So, for 8-10% topline growth, with some margin expansion, Colgate can actually grow its earnings at teens for the next few years. In fact, that is exactly what Colgate had achieve for the last 10 or even 15 years, with even lesser topline growth.

Colgate's tremendous but yet stable growth is demonstrated by its dividend track record. Colgate has increased its dividend for the last 47 years! Needless to say, it's one of those admired Dividend Arisocrat and it's just going to keep growing!

Next post, we look in detail at its dominance in oral care!

The Oral Care Industry

Value investors love mundane sectors and what could be more mundane than brushing your teeth? Nobody ever talks about brushing their teeth, how they enjoy it or how they look forward to it every morning. Well basically I think nobody does, that’s why it’s never been talked about.

But as far as investing is concerned, this is one of the best business to be it. We will talk about a few important points:

Everyday Necessity (Consumer Staples)

Well, first of all, everyone brushes teeth at least twice a day right? Toothpaste runs out fast, and people just buy back the same brand without thinking too much. Even if prices were up like 20%, they will still buy it. After all it’s something going into your mouth. If it’s going from $5 to $6, most people wouldn't risk switching to something that doesn’t taste right.

And toothbrushes, they wear out fast too! Not to mention dentists keep recommending that you change yours every 2 months. So it’s a business with growing recurring demand, as long as world population grows.

This is also the beauty of consumer staples. Hence they usually trade at a higher multiple vs other cyclical sectors.

The Industry Structure

The business model may be great but if there are too many competitors, it drives margin down and there is little money to be made. The strange thing about the oral care industry is that globally, there really aren’t that many players. Basically there are only 5, and they control 70% of the world’s market. The top 2 guys alone, Colgate and P&G, controls 45%. So it’s an oligopoly.

When the industry structure is such, the top players have the pricing power and they call the shots and the 3 minor players will follow. Of course they are also cognizant that they can only raise prices to the extent that consumers won’t be put off. If toothpaste becomes $20, I think a lot of alternative brands will appear and most people will switch to them immediately.

However the top players would choose to raise prices just enough to keep people from switching. In fact, given their size, they can lower prices to kill competition when they see fit. That is the power of oligopolies and monopolies.

Well, it’s not so good for the consumers though.

Emerging Market Growth

As with most consumer staples, we can expect steady growth as long as consumption grows. Specifically for oral care, growth rate can actually be high single digit driven by volume increase (as global population increases) and price increase (which should keep in pace with inflation, if not more) over the long run.

It is worth noting that this high single digit growth is also mostly driven by emerging markets. The number actually breaks down to low single digit growth rate for developed markets and teens growth rate for emerging markets.

So having exposure to this industry is basically another way to bet on the growth in the emerging markets. The difference is that you probably pay a fraction of the multiple of the actual consumer staples in emerging markets. (Well the growth rate is also lower bcos the base includes developed markets)

Next, we look at the main player in the market!

DB Brazil ETF - Part II

The second risk is China's decreasing steel consumption.

The last five years saw China's big ambition to develop its infrastructure and mass market condos for its people and hence steel consumption went through the roof, resulting in the bull market in steel and shipping (of iron ore to make steel). That party is now probably going into its 11th hour and Cinderella is ready to drop her glass shoe.

China needs to shift its economy from manufacturing to services, which would need less steel and hence less iron ore. Not to mention that after getting squeezed by the Australian and Brazilian iron ore producers for so many years, China is also aggressively pursuing new avenues of supply in other regions like Mongolia and Africa. This means new supply, less pricing power. So the iron ore story might not have a happy ending.

The saving grace for the iron ore producers would perhaps be bargaining power. With 3 guys controlling 80% of the market, basically they call the shots. They manage the supply, make sure there is always just enough. They manage the spot market, make sure that it stays elevated, then the contract pricing would have to follow.

In the longer run, it is also worth noting that steel consumption is very much integral to the development of our civilization and it will continue to grow. China may have peaked, but S.E. Asia needs a lot steel in the next few years. Not to mention Latin America would probably step up, which will benefit Vale. After that we have India. So maybe there is still hope.

To sum it up, the Brazil ETF makes a lot of sense, especially for the long run. Pricing wise, it is currently 25% below its all time high. It is likely to surpass that in the next 5 years.

As to downside, well, there is about 70% to its Lehman low, but it's not likely to go there bcos there is some valuation support. I would say it might go to 1.3x PBR or PE of 8x, ie 30% decline from current levels. But if that happens, then it's time to buy more!

Well just to sum up here:

Pros:
Exposure to Energy, Iron Ore and Brazil
Cheap valuation at PER 11x with 3% dividend yield
High single digit long term growth rate
Often at discount to NAV (due to tracking error - see below)

Cons:
Replacement of oil and China's slowdown
Low liquidity (10,000 shares traded per day only)
High tracking error (does not track the index well)
70% from absolute low

DB Brazil ETF - Part I

Last checked, there are now 75 listed ETFs in Singapore. As blogged a couple of times, ETFs present an easy way for lay people to invest into stocks and shares without having to put in too much effort (ie do a lot of study and research). Basically, you just buy into the regional/sector growth of the ETF. To learn more, simply click on the ETF label at the end of this post.

Today's post is about Deutsche Bank's Brazil ETF listed on SGX. It seemed like this might be one of the cheaper ETFs out there amidst global bullishness on Emerging Markets.

Brazil has the 8th largest economy in the world and it is projected to be in the top 5 in the next 20 years. GDP growth should be a high single digit for the foreseeable future, although a tad weaker than China, its cheaper valuation more than make up for it.

The Brazil ETF trades at a PBR of 1.7x, 1 yr forward PER of roughly 11x and gives a dividend of close to 3%. Although not as mouth-watering as in early 2009, I find such valuations quite acceptable, given its growth profile. And definitely cheaper compared to China.

The components of the ETF are basically just 4 items.

1. Petrobras, the oil giant with its mega oil-field currently under-development.
2. Vale, the iron ore major, which depends on China's appetite for steel.
3. The banks, which basically mirror the growth of Brazil.
4. The consumer staples, discretionary and utilities sector in Brazil, ie the Brazilian economy.

These four sectors roughly make up 25% each of the ETF. So basically, for every dollar put in, 50c is betting on Energy and Resource, and the other 50c on Brazil itself.

The first big risk here would the replacement of oil. As we all know, when oil hit $150 per barrel during the heydays, it really gave a wake-up call to the guzzlers of the world (which is pretty much everyone), reminding us that being held hostage by the Arabs is no fun and we better start to reduce our dependency on this energy source derived from the remnants of the dinosaurs.

And so, the techies of the world started their engine and ventured out there looking for new energy sources. We are now going big into nuclear, wind, hydro, oil sands, shale gas, solar and even human dynamo in Africa. Of course, we are also trying to use less at the same time, ie more hybrid cars and EVs. Now this is definitely no good for Petrobras.

Well, fortunately, I think the mitigating factor would be that it takes a long time for these alternatives to actually come to the market and finally free us from the Arabs. So meanwhile, we want to develop other big oil fields to limit their market share of oil. And this is where Petrobras and its mega oilfield comes in. And it is in the interest of the world to develop this and make it work.

Next post, we touch on another risk and round-up this topic!