Thursday, January 28, 2016

Lessons Learnt: Sembmarine and Keppel

Our beloved oil rig manufacturers had suffered a catastrophic decline in the last 18 to 24 months. Keppel fell from $10 to $4.8, a 52% drop and Sembcorp Marine collapsed from $4.5 to $1.5. a 66% free fall. Sembmarine's parent Sembcorp Industries didn't do that well either, falling from $5 to $2.2, again a more than 50% decline from its peak. All three stocks now trade below book, with single digit PE, with no recovery in sight. Apologies to anyone who had took advice from previous posts and bought these stocks.

Investing is as such. 40% of the time we get things wrong. With discipline and experience hopefully our wrongs are just 20-30% drops while our rights are home runs at 2-3x, which makes the overall portfolio return decent. Once in a while we would get these disasters. Then it's vital that we learn our lessons, take down good points and become better investors with them. This is the objective here today.

The original thesis with Keppel and Sembmarine was quite simple: it was a bet on energy, they were top global players in their field and they had exposure to growth in Brazil, US, North Sea, Middle East, which were growing very well not too long ago. Let's elaborate on these points:

1. Energy was the place to bet a few years ago. We have all been taught that we would run out of oil in time. I remember the limit was 20 years when I was a student 20 years ago. My teachers told me that the world would run out of oil in 20 years. Again that prediction did not come true. But it would also be true that we wouldn't have more oil right? Well we now have LNG and shale gas but still, it's not sustainable to just keep digging from our planet. Considering the growth of global economy, it's probably not incorrect to think that we cannot continue to rely on Mother Earth for fossil fuel forever. So the energy bet should be a long term positive return bet, we will run out of oil, oil price will skyrocket, Keppel and Sembmarine benefits from that. In theory.

An oil rig

2. Global #1 and #2: These two firms are the top manufacturers globally with combined 60% market share in oil rigs and they also have the technological advantage to do more. Both firms also started building other equipment like drillships and floating platforms. They also had very good global brand names and won large orders from Brazil, which unfortunately became the major cause of their downfalls. With dominant global share also meant that they had economies of scale, they could procure raw materials cheaper and could built the final products at lower costs vs their competitors. One very important factor that was not talked about was also the designs of the rigs. There are only 3-5 designs globally and both firms went to acquire these design firms years ago to make sure that the important ones would be kept in-house. This meant that future competitors i.e. the Koreans and Chinese would not be able to lay hands on these superior designs. They had to buy from the the remaining 1-2 independent designers out there which meant higher costs both for the design payments and the construction of inferior rigs. So we are betting with the winners, what could go wrong?

3. Betting into Brazil, US, North Sea and Middle East. It's always good to diversify our bets and it came as a good idea to be able to buy Singapore firms that had exposure in some of the fastest large growing economies. Again, that looked pretty good just a few years ago. Now the collapse in oil as well as other issues caused a lot of these economies to face serious growth impediments. It's consensus now not to invest in these markets at least for the next few years. 

So it was really a perfect storm. A metaphorical oil rig blow up like the one BP had in the Gulf of Mexico. Well, so much so for the past, what are the lessons learnt and what could we do better?

The biggest overlook here would be the crude oil price cycle and oil related heavy equipment investment cycle. While it's true that the world is short of energy and would likely be even more short going forward, it's also true that such cycles come and go and across decades. The following chart shows the prices of crude oil going back to the 19th century. We can see that crude cycles last for decades. Of relevance in recent times, one would need to look at the oil shocks in the 1970s and the long lull in the 1990s.

Long term crude oil prices

So analyzing Keppel and Sembmarine's ten or even twenty years of financial statements wouldn't be enough. We would need to see what happened in the 1990s and better to go back to the 1970s during the oil shocks. Obviously, that's a lot of work given that most readers here might not had been born in the 1970s. So while looking at the free cashflow (FCF) for Sembmarine from the late 1990s we see that the firm could do SGD 100-200m per year, this was not enough information. Looking back long enough, we would know that oil capex cycle could be as long as 15 to 20 years. There could be a period of time of maybe five years or more when these firms had mediocre or no FCF. Armed with this info, it looks like Sembmarine could be stuck in this state for the next few years. So that's the first lesson, not going back into history for long enough.

The other lesson learnt would be the most important lesson in value investing: it's not having enough margin of safety or MOS. When it was first proposed here that these are interesting stocks to look at, Keppel was around $8 and Sembmarine was around $3. They had fallen 20-30% from their peaks, FCF was strong based on the last few years, dividend was decent as well. Back then, the thinking was that, for these bellwethers in the Singapore stock market, getting a 3-4% dividend at mid teens PE were probably good deals. This was very gullible thinking with very little margin of safety.

Value investing doctrine taught that margin of safety should be at least 30%. Clearly with only 20% discount from all time highs didn't cut it. It didn't help that these were not staples or software, ie businesses with very low capex needs and high ROIC. These businesses were cyclical with different dynamics. Greed and exuberance in good times were culprits too. 15x PE looked cheap in bull markets, not across cycles. Well, markets are fair and whatever lessons that weren't learnt well enough would be taught again. So with oil prices crashing to $30 and these stocks falling over 50%. This margin of safety lesson come right back to haunt. So it's worth stating here in bold again: the three most important words in value investing is margin of safety.

Investing is as such, the future is unpredictable. Who would have predicted just a few months ago that oil would crash below $30? But having said all that, there are a few saving graces. Oil could easily rebound to $60 with some catalysts: be it Saudis cutting back production or some supply shock somewhere. Punters would drive these fallen angels back up a good 20-30% if oil rallies 100% (from $30 to $60). So that's a short term plus albeit a big "if" for oil to rally back to $60.

Also, other parts of the long term thesis remain intact. They are still the strongest players out there and they will emerge stronger in the next cycle even though it's far away. The Koreans and Chinese would fall further behind given the lack of scale and access to the all important rig designs. There could be value emerging now amidst all the doom and gloom. What's more, the firms themselves are not sitting still. There is now talk that Keppel will be reorganizing the whole group including divesting other parts of its business to unlock value within the group and also to raise efficiency. This would create both cashflow and increase its market value. 

For Sembmarine, it is rumoured that its parent Sembcorp Industries might buy it back and restructure it to become a stronger player. So it could be a buy for both entities. It's a buy for Sembmarine as the parent would likely pay a 30% premium to take it private but it's also a buy for Sembcorp Industries because they would be able to acquire a good business cheap and ultimately extract some value by creating cost and sales synergies. All three firms are now trading at 8-9% FCF yield on normalized FCF, below book and near their GFC lows. As the saying goes, it's the darkest before dawn. Hope that the light shines on our oil rig builders soon.

Last words: Lessons learnt help us become better investors over time. Hopefully this serves to remind us always to look back into history for as long as it takes, have enough margin of safety and think more holistically about cycles and capex businesses.

Monday, January 04, 2016

Happy New Year! Let's talk about REAL Investing!

Happy New Year folks, it's 2016. This year is meaningful in a way since this site started out in 2006. So, a decade just whizzed by with some intermittent writing, some charts and lots of thinking and oh yes, thanks for supporting this site for the past 10 years! It's been great so far, and there's another 40 more years to go! We are on track to at least match Berkshire or SG50, and it so happened that Berkshire is actually as old as Singapore and celebrated its 50th anniversary in 2015. So in 2056, we shall have 8PA50 or something. Do hang around! 

Today we would like to discuss some interesting notions about investing, and hopefully correct the layperson's perception of what real investing is all about. To most people, investing likely equates to making money in a money's game, which is linked to trades, making good speculation, being some hotshot trader, like those protrayed by Hollywood, especially in the film Wall Street starring Michael Douglas. In the Singapore's context, some might remember Da Shi Dai, or The Greed of Man, an epic Hong Kang drama series about stock manipulation that propelled a few young actors back then to stardom, like Liu Qing Yun and Vivian Chow.

DVD Cover for Da Shi Dai

Well real investing is nothing like what was portrayed in dramas, movies etc. But the images stuck. Today, when we think about investing, we probably linked it to all of the above: speculation, manipulation, big money game making the rich getting richer etc. Most would think it's a good way to get rich quick. Singaporeans, luckily or unluckily, get exposed relatively early, like in universities but soon learnt this game is really not that easy. Armed with some rudimentary knowledge, a desk and buying a PC for this purpose, we think we could make big bucks. Aspiring one day, our desks would look like those portrayed in the movies. Maybe like the one below:

A dream desk

A desk full of screens, with live prices and we become some hotshot investors sitting in plush chairs. That's the image for most people perhaps. They think that an investor's job would be to monitor markets day in day out, keeping updated with real time news, understanding price movements, making lots of trades, looking smart. Sorry, that's all just in our heads. None of these are close to any truths. A real investor's desk looks like the one below:

Warren Buffett's desk

For Warren Buffett, he doesn't even have a PC although most modern investors today do have a basic one, for news, excel and online trading. The truth is, an investor's job is really to read and to think. Hence the real desk would be filled with books, reports, newspapers, magazines more reports and more things to read. Then we have the all important thinking tools ever invented: the pencil and the paper. That's the truth. That's real investing. Okay today we need Excel to crunch some numbers, but when we do reach for Excel, the bulk of the mental work is over. Hence the real job is to read and to think. To think better that all the amateurs out there. In order to achieve that, it's also important to discuss. To challenge ourselves by talking to like-minded people, people who are smarter than us to point out our mistakes and of course people whom we love to hang out with. So read, think, discuss. If we have to surmise the real job of investing into three words. That's the three verbs.

What's so difficult then? If it's just the three verbs. Well, golf is also about swinging a stick to hit a ball, but it takes years to master right? Simple things may not be easy to accomplish. Take reading for example. Most adults today read some stuff, like the newspapers or books or magazines but to be a disciplined reader takes a different mindset and perhaps it's really a different skill set. In fact, most people would not be able to keep reading for hours on end. Personally, I find it hard to sit down and continuously read for more than an hour. And I don't recommend trying to be a four-hour bookworm to be a good investor. Maybe an hour or two per day would be enough, excluding newspaper reading. We have tons of other things to do still.

Thinking would perhaps be the hardest skill set, and it ties in with discussion. It would be easier to brainstorm with friends than to think alone. But it's not every day that we get to meet all our friends, so it might be useful to spend some time thinking everyday. That's perhaps the most important one to two hours we could ever spend. Again, it's not easy. Based on my personal experience, I usually squander these precious minutes randomly surfing the net. Before knowing it, the hour is up and I have to get back to real stuff, like laundry, or playing with the kids.

What about the portfolio? Or stock trades?

Well, the truth is, real investors don't spend too much time on these either. It's all thinking. When the time comes to enter the trade, it takes a few minutes. It cold be weeks of work done that led to the few minutes. It's just like pressing the final red button. With no drama. In fact, one value investor recommended never to put in a trade during market hours. Do it before and go to sleep. That's because the daily fluctuation of 2-5% shouldn't change the decision to buy a stock which could double or triple. The real time prices are just distractions.

As for portfolio reviews, the optimal frequency could be quarterly or longer but that's too far away for most people, so perhaps a monthly review would work but perhaps just reviewing a part of the portfolio. Long term stuff doesn't change weekly or monthly so it doesn't make sense to be doing reviews too soon. Say with a portfolio of 20-30 stocks, a monthly review on 2-3 stocks would work well. So we get back to the same stocks after 10 months. More on this on another post.

So putting it all together, a real investor could have a work plan as follows:

1. Read newspapers (at least 2: ST and FT)
2. Writing down relevant notes
3. Doing good in-depth reading

1. Read at least one magazine (the Economist)
2. Discussion with friends
3. Immerse in good long term strategic thinking

Monthly or Quarterly
1. Review parts of the portfolio (more thinking actually)
2. Consolidate relevant trades and key them in

So, that's the truth about investing. It's boring reading, thinking and occasional chats with other investors. Once in a while, we get to kick the tires, go for factory tours or AGMs but most of the time, it's desk bound and pretty lonely way to work. But if we keep going at it, someday, we get to be quite good. That's when things shine through. 

To show with a bit of a stretched analogy, we come back to one of the stars of Da Shi Dai or The Greed of Man, Ms Vivian Chow. Here's how she looked in 1990, some 25 years ago.

Vivian Chow, 1990

Most male bloggers should be drooling by now. She was the girl-next-door star in Asia back then. She couldn't sing and her acting skills were so-so but who cares? Her posters were all over army barracks and teenage boys' bedrooms. Then she got tired of show business and disappeared. Only to reappear a few years ago. Here's how she look today.

Vivian Chow, 2015

Man! She looked even better, right? So people asked, what's her secret of keeping herself so beautiful after so many years. Her answer was simple yet profound. Every day, she strives to be happy, maintain her health and smile. That's it. If we take the liberty to translate that into three relevant verbs, it might be: exercise, eat right and smile. Do enough, and we can conquer aging. Beauty is a mere reflection of our internal construct and accumulation of our daily thoughts and actions. We keep them positive, we are good.

So to be a good investor with a solid portfolio, would require, similarly, the correct internal construction: the right thinking and good ideas from daily reads, insights and also the good temperament to execute the trades free of greed and fear. The portfolio would then be the reflection of years of wisdom and compounded growth, filled with quality companies with exposure to various sectors, secular trends and themes. And it all starts with these three verbs: read, think, discuss.

A belated Happy New Year to all!