2017 in Review: Melting Up, Up and Away!

In a blink of an eye, we are now at the end of 2017. Last year this time, we did a similar review for 2016 and then talked about how 2017 would pan out. The following passage surmised what we discussed:

Let's talk about 2017. Remember it's not prediction but preparation. It's not easy but let's try. In my view, 2017 could see the rise in animal spirits given the very bad 2016. Investment appetite especially with the US economy recovering could pull parts of the world up. Although China and Europe should remain tough with the bad debt issues still haunting the financial sectors. So what's the preparation needed? Maybe look to deploy a bit into secular sectors, like health and fitness. Meanwhile in Singapore, 2017 could be the year the property oversupply hits a peak after which the no. of new condos would drop. Hence it might mean it's the bottom for the property market. It's could be the last chance to buy Singapore property before it becomes way too expensive. So, be prepared!

Quite miraculously, we got many things right! We saw animal spirits coming back which led to the rising bull markets globally. The US markets are up 20-25%, Europe up 21%, Japan up 19%. Hong Kong up over 30% and China 25-50% depending on which index we took. The US economy recovered well enough that market participants are talking about things being too heated up. Elsewhere investors shrugged off Europe's lingering issues and China's debt problems and looked for excuses to bid things up.

The crazily prominent example of this is Bitcoin. 2017 saw the bubble formation of bitcoin in its final stages and we are now witnessing the meltdown. During the same time last year, bitcoin was trading at $800. A few week ago, it hit an all time high of nearly $20,000 before crashing 50% to $10,000. At its peak, the total market value of bitcoin hit USD 300 billion, which is bigger than Singapore's GDP. Alas, all good things come to an end, we should be seeing bitcoin crashing back to earth and then forgotten, as with the tulips, internet has-beens and pencil buildings in Japan constructed voraciously durring the 1990 property bubble.

Bitcoin Mania

For Singapore, 2017 also had some significance. We saw the public dispute of the first family being brought to public while our property market staged a nascent recovery. The markets were oblivious to the spate, investors' confidence in both stock and property markets remained strong. Who cares if Oxley Rd becomes a museum or another luxury property address in the little red dot? Singapore will be the rich and famous playground in South East Asia, the Monaco of ASEAN.

However the saga also marked the signs of tumultous times when power transfers occurred, alongside other incidents such as the seizure of our Terrex armoured vehicle by China and my personal favourite: Tesla cars being taxed as environmentally unfriendly by our beloved LTA so much so that Elon Musk called our PM to settle the issue. Longer term, I cannot help but worry. We came far on the foundations built by the first generation of forefathers but the infrastructure (both the soft and the hard ones) is not robust. There are issues with our education, healthcare and transport systems, amongst others. Big issues!

In five to ten years, we will have a new prime minister and his new team, untested and unproven. We must give them support and we have to fix the abovementioned issues if we want Singapore to be relevant beyond 2050. But meanwhile, property should be okay. Fortunately or unfortunately, Singapore will become a safe haven for global wealth to find their ways into private properties in District 9, 10 and 11. Alas, most Singaporeans will not be able to afford condos in the not too distant future as we see $2,000 to $3,000 psf condos become the norm as with HK, London and Monaco (and the most exorbitant to hit $10,000 psf). The 5C dream shall remain a dream for 90% of Singaporeans.

Well, that's the future, back to the present moment, so what's installed in 2018?

I think the apt phrase to describe 2018 might be what is alluded to in the title. We will witness the markets melting up, up and away! What's that? Well, essentially, we might see a bubble. But exactly, what's a melt-up?

Meltdown? Melt Up?

Here's a definition from Financial Times:

A 'melt up' is the informal term used to describe markets that experience a rapid rise in valuations due to a stampede of investors anxious not to miss out on a rising trend. Gains caused by melt ups are usually followed quite quickly by melt downs. 

In my opinion, a melt up is probably indistinguishable from a bubble. It might be a semi-formed bubble and not a full blown one that we saw in 2000 but really, what's the difference? It just means that we will see prices going up, our portfolios showing gains but nothing much fundamental really changes. The prudent investment strategy during melt-ups or bubbles is to sell incrementally. But this is easier said than done. Because after every sale, we feel damn stupid as we see the stuff we sold going up further and we question whether we sold correctly. Maybe we should have waited for a higher price. That is the dilemma. So that is why a better strategy might be to sell in tranches. Ideally we keep selling until we are 50% or more in cash at the peak of the melt-up so when it finally crashes, we will have the firepower to buy. So 2018 might be the year we need to raise cash substantially if we are fully invested now.

The other interesting investment angle, as with what happened during dotcom was to buy good old economy stocks at cheap valuations. We are seeing some of these opportunities presenting themselves as every market participant out there is just thinking about buying FAANG (Facebook, Apple, Amazon, Netflix and Google), BAT (Baidu, Alibaba and Tencent) and the rest of the internet powerhouses at 30-100x PE. At the other spectrum, great companies in consumer staples, pharmaceutical and healthcare are trading at teens multiples. Hopefully we can uncover more of these awesome stock ideas in 2018.

Wishing all readers a Happy New Year! Huat Ah!

Chart of the Month #7: Living Longer

Here's another Economist chart depicting one good reason that we are living longer - we are winning the war against cancer! We are seeing close to 100% five year survival rate for some types of cancer thanks to drug innovation and medical advances.

As you might know, cancer is not one disease but actually many different types of ailment manifested in different ways. Some are caused by viruses while others are related to lifestyle choices like smoking, eating too much red meat, exposure to carcinogens and what not.

But advances in medicine is slowly but steadily postponing death. The amazing drugs launched in recent years help to activate our own immune system to fight cancer cells by successfully labelling them with ingenious techniques - which unfortunately is beyond me to explain how and why in detail. 

What I know is that reason why we had failed to tackle cancer in the past was precisely because our own immune systems always think that cancerous cells are our own body cells and hence allowed to multiply and grow, causing havoc to the rest of the body. But these new drugs found a way and they are working.

Hopefully, with more innovations in the next few years, we can finally eradicate this death sentence for good!

And with that positive note, here's wishing all readers a very Merry Christmas!

Chart of the Month #6: Pearl River Delta

Here's an interesting report from the Economist a few months back. It described how the Pearl River Delta of China is now an innovation hub and a region of the future. The left chart shows that number of international patent applications. The data ends in 2016 but I suspect that China had already surpassed the US in 2017. China is now world's largest patent market today.

The right bar shows that the bulk of the patent filing comes from Shenzhen, arguably already surpassing the Silicon Valley. The city that Deng Xiaoping first visited on his Southern Tour and declared that China will rise, starting from the Pearl River Delta. Indeed, we have seen that transformation especially with the internet big names like Tencent and Huawei. 

Here's a list of the most innovative and interesting Shenzhen based companies other that the two mentioned above:

1. BGI (Beijing Genome Institute - shifted to Shenzhen)

2. BYD (automobiles)

3. ZTE (mobile phone)

4. Mindray (medical device)

5. Vanke (property developer)

6. SF Express (logistics)

7. Hangzhou Hikvision (security camera)

8. DJI (drone)

In 2013, we discussed that China had a huge conundrum because it lacked certain decencies, corruption, deceit and counterfeit ruled the day. But it seemed that things are changing. The anti-corruption campaigned started by Xi Jin Ping since those days had continued and might really be working. Deceit increasingly doesn't pay as society matures and businesses look for recurring customers and building trust brings more money that cheating. The shared economy and e-commerce require trust as a bedrock principle to work, which is why China internet companies need to establish that asap. And lastly with innovation, China is beating counterfeit left-right-centre.

Hence, the 21st Century truly belongs to China. It might still take some time to get to where US and Japan societies are in various aspects but it may not be 50 years as described in the conundrum post. That's the thing about prediction! Nobody ever gets it right!

Inspecting the Vicom Story - Part 2

This is a continuation of the previous post.

Okay, in the last post, we discussed the basic stuff about Vicom. It is hugely cash generative and we are getting it at low teens PE, 13x to 16x PE for a 30% operating margin, 20% ROE business. This is really not expensive, albeit the growth angle could be questionable. Singapore is a mature economy, our vehicle population is maxed out, we don't have enough roads for more cars. So how to grow?

Maybe Vicom is cheap because there is no growth. Or is there really no growth?

This is where it gets interesting. In stock investing parlance, we call it optionality. Optionality refers to potential upside that is there but we do not know if they would materialize. Usually, if they do, it means a lot more upside but if they don't there is also not much downside. It is said that the best investment portfolio is simply a portfolio of free optionalities.

To delve further, this optionality concept comes from the big branch topic in finance simply called options which were created as early as 600BC by Greek mathematicians but only well understood when two Professors put on their thinking hats and solved the puzzle in the 1960s. Their theory won the Nobel Prize and today, all finance students have to study what they created - Black Scholes Option Pricing Theory. Rings a bell?

Call option chart

The simplest option chart (above) shows how the downside is capped if the stock does not move or in the unfortunate event, even if it goes down a lot, the option buyer only loses his premium (capped at $200 in the chart above) and face no further downside loss. But in the event that the stock price goes up, the option buyer stands to benefit from all the upside. The catch is that options expire and the deal is off once the option hits expiration date.

In a more general context, optionality refers the similar asymmetry in risk and reward but with no expiration date. The catch is that most optionality do not really materialize which is why it is not worth much in the first place and the market refuses to pay for it. The sector with the most optionality examples would be the pharmaceutical sector. Pharma companies are always researching on new drugs and nobody knows which ones would be the next blockbuster drug. The example that comes to mind would be Pfizer and Viagra. 

Back in 1996, Pfizer was just another pharma stock trading at $5. It was not small though (market cap at that time was already USD 40bn!). It generated a billion plus dollars of free cashflow with its huge portfolio of drugs. But in the same year, it filed the first oral drug for erectile dysfunction (ED) - Viagra. Nobody knew how big the market would be. There wasn't such a market in the first place. Men with ED just lived with it, unless it's super serious then they go drink Tongkat Ali or eat oysters or something. There wasn't any medical treatment for ED. If the drug failed, then Pfizer would just continue to make its billion dollar annually with its huge portfolio of legacy drugs and the stock would be $5. As it turned out, Viagra became the biggest hit ever, allowing old men to have sex again and the stock went 5x to $25. At its peak, Viagra sold roughly $3 billion annually. 

Tongkat Ali, herbal treatment for ED in S.E.Asia

So that's optionality. Pfizer was (and still is) a blue chip (now with the blue pill :), if one had bought it then at $5, one could enjoy the blue chip growth (maybe just single digit) and collect a stable dividend (2-3% dividend yield). If Viagra didn't happen, then it's decent growth, or rather, just blue chip growth and dividend. But when Viagra happened, then we are off to the moon. In fact the stock raced very early on as the market simply got excited even before the drug was launched. It more than doubled from 1996 to 1997 despite cashflow being weak in 1997 at only $600m (normally it should be above a billion dollars. Today Pfizer is a $200 billion market cap company.

Let's move back to Vicom. So what's the optionality? I see a few:

1. Price increase for inspection

2. Overseas growth

3. Buyout by ComfortDelgro

The first optionality is just about the timing of price increase. At some point, prices go up like everything else in Singapore. We just don't know if it is 2 years or 5 years. The history shows that the industry had a habit of raising the inspection fee every few years. It was $50 in 1997, then it was raised to $54 in 2001, then $56 in 2005 and then $58 in 2006. Based on its website, current fees are $62 inclusive of GST. This relentless price increase would simply continue bcos first it is nothing compared to the price of the vehicle (more than S$100k in Singapore today for a 1.6L car) and the other costs such as fuel, maintenance and what not. Every price increase again drop directly to its bottomline since there is very little cost in between. So even with the population of vehicle stagnates, Vicom can enjoy revenue growth. This is the beauty. Guaranteed revenue growth. Of course, the cherry on the cake is that Singapore's vehicle population will only go up. We need more buses, trucks, taxis every year. Passenger cars will also just keep growing bcos it is an aspiration to own an expensive car in this warped bubble on a little red dot. The market doesn't see this now, but when it does, that's when our option gets exercised!

Overseas growth is a new angle that is not being talked about right now. But the potential is huge. Singapore, for good reasons, is seen as a leader in standards by our neighbours and a few of them are very happy to bring Singapore companies into their country so as to learn from us. Vicom talks about opportunities in Vietnam. In the same vein, countries like Myanmar, Laos, Cambodia would one day require inspection and testing. Imagine if Vicom could just get 1 or 2 of these markets, or rather just a small slice of one of these markets, the potential is a huge increase in revenue. Vietnam alone has 100m people. Of course, this scenario is still pretty remote. There is nothing concrete yet. 

The last optionality is similarly remote though not zero probability. ComfortDelgro (CD) today owns 67% of Vicom and it is not inconceivable for them to buyout Vicom given that it's such a lucrative business. Why give away that 33% to others? Of course they also want to buy back at a good price which is why nothing has been done all these years after the stock ran from 50c to $5. So the other way to look at this is that if Vicom falls too much, Big Brother CD will just buy it out. Hence there is an inherent floor price to this stock. Our downside is capped much like a call option.

In a red dot not so far away... car wars

But given that Vicom is now a $500m company. CD needs to raise $150m to buy the 33% it doesn't own. With its woes, thanks to Uber and Grab, it would rather put money into this car sharing war to defend itself than to buy back Vicom. (CD only made $100m in free cash flow last year. So it's not a small sum for them, although one could argue that effectively they only need to raise $50m since Vicom has $100m on its balance sheet!) In any case, it might just be status quo for now. Some day they might buy Vicom, but not today.

To sum it up, Vicom has all these optionalities, but it is hard to put them into numbers. So we are paying c.$400m (after accounting for the $100m on its own balance sheet) for a steady $30m free cash flow. This translates to 7.5% free cash flow yield or 13x PE after adjusting for cash. The rest of the options, if it happens, comes free. With bank account interest rate at 1%, property rental yield at 2%, I would say 7.5% yield is pretty decent. In fact, 4% (or more in the future) would come back annually as dividends since they don't know how to deploy the huge amount cash coming annually.

That's basically why Vicom is a buy! Read from the first post.

This author owns Vicom.