Chart of the Month #8: Flattening Yield Curve

This argument came about in late Nov when some prominent economists noted that the US yield curve is flattening and might invert soon. Flattening or inverting yield curves are big deals bcos they were followed by recessions 7 out of 8 times since WWII. The chart below shows just that.

As you can see, we are likely to head into another one as the 10yr-3m spread goes to zero, which implies flattening or inverting yield curve. 

The economic rationale is weak though. Why does a flattening yield curve causes recession? One reasoning postulates that banks, the lubricants of a vibrant economy require steepening yield curve to make their spreads, so if spreads turn to zero, it would mean they cannot lend money and hence economic activities grind to a halt.

Another reasoning goes like this: short term rates rising to meet long term rates usually means central banks are entering into tightening mode, which again put the brakes on the economy, causing recessions.

However, it seems that this is not going to happen at least until late 2018, so meanwhile the party goes on! Huat Ah!

Singtel: Becoming A Dumber Pipe?

I have been a long term shareholder as well as a long term mobile phone subscriber of Singtel. The experience had not been great, to say the least, especially in the past three years. Singtel's stock had done okay if we look back in time. It was $2.2 or so in 2007 and today it's $3.7. An investor who held throughout would had made 68% on capital gain and another 40% or so in dividends. But in the last three years, it did nothing. Meanwhile, DBS went from $15 to $25 and became the largest stock in Singapore (overtaking Singtel) for the first time ever!

Today, we try to decipher what happened to the #1 stock in Singapore.

Singtel's investment thesis had been pretty simple. This was a business connecting 600 million mobile subscribers over a huge part of the world. It generated tremendously strong free cash flow averaging S$3bn annually over the past 10 years with almost 2/3 coming from overseas. It is the #1 or #2 player in Thailand, Australia, Indonesia and Philippines. In Singapore, being the biggest brother, it led the way in screwing subscribers and generated huge profits year in year out. What more could investors ask for?

Big Brother - Singtel

For the longest time, it was also the proxy for Singapore. Equity investors looking to buy into countries usually look for proxy stocks. If they believe that a certain country had growth prospect and would like to play on that theme, they would buy a stock to express that view. So Singtel is the proxy for Singapore, just as Astra would be the proxy for Indonesia and Samsung for Korea or TSMC for Taiwan. However, there are also bigger themes at play. Just as Samsung and TSMC are now being associated as core stocks for the new tech wave, Singtel is facing heaps of trouble.

It is becoming a dumb pipe.

The dumb pipe argument on telcos has been around for some time. The theory was that as internet advanced, telcos would lose their relevance in the new paradigm as apps, transactions, gaming take place outside the telcos' dominance. It started with Whatsapp killing off SMS, then voice and now perhaps even data. In order to defend profits, the telcos keep setting up traps to squeeze money out of consumers.

As an example, international data roaming and international phone calls had become exorbitant. Data roaming is easily $25 per MB. If you are reading this on your mobile phone in Afghanistan without an overseas roaming plan, you might be paying $125! It has gotten so ridiculous that we hear about $1,000 phone bills and it goes on Straits Times and Singtel had to come out with some backdating-the-charges-via-a-cheaper-plan way to lower the charges. Meanwhile their call centres get flooded with waiver requests and they have the guts to claim that they are helping customers save money!

Ridiculous overseas charges

So is it just a dumb pipe or a dumber pipe?

But back to the original threat from apps and internet - this is real. SMS revenue fell drastically since Whatsapp came about. Now that voice quality had improve, people are using Whatsapp for calls too. So the only profitable arena left became data, which is why we see exorbitant data roaming charges. Now Google saw this chance and recently decided to jump in with a way to screw the telcos. It is rumored that they might offer phones with flat fees for global data usage. Now this is a gamechanger. It this really happens, it would be goodbye to all telcos, all over the world.

That's what telcos get for screwing subscribers all these years. Remember Google's company motto is "don't be evil". Not that they are living up to it, but they are certainly aiming to eat Singtel or for that matter every telco's lunch.

Singtel knows this is coming. While screwing subscribers they have also been investing in new ventures. Alas, no traditional telco had succeeded in spending money to grow new businesses. Singtel touted its small success in cybersecurity. It claims that it is the #5 player in the world in the field of cybersecurity. But if we speak to the real cybersecurity guys, they would be like, "Huh? Who is Singtel? So, it's a stretch to say they are good here. But who knows, they might make it, cybersecurity is a nascent market, things can change quickly.

Unfortunately, these investments need money and with money going into investments means less money for shareholders. The lines above shows that while dividend per share had been kept constant at 74% of earnings per share, it had shot through the roof as a % of free cash flow. At this rate, Singtel would be borrowing to pay dividends. Perhaps that is why it has been overtaken by DBS in terms of market cap. 

Having said that, Singtel is not going to crash 40% tomorrow. At S$3bn FCF per year, it is trading at a healthy 5% FCF and the market might still give it the benefit of the doubt. It can still become a smart pipe. Meanwhile, it will continue to screw subscribers and squeeze more cash out of everyone of us. Singaporeans pay one of the highest phone bills globally while suffering from poor network quality and exorbitant overseas roaming charges. Not unlike our public transport and our education system, we get the crap underneath the cleanliness and the efficiencies that our infrastructure promises. Geez, that's quite worrisome, isn't it. 

It is a dilemma to be a suffering consumer but a shareholder of Singtel. As a shareholder, some of the pain is mitigated with the dividend and the capital gain over the years. But as we now know, Singtel could become a dumber pipe. With the 4th telco coming up, it might really stir up competition and grab a piece of Singtel's pie. Especially with most subscribers suffering so long and would be more than happy to switch. If the Singapore cash cow is slaughtered, we can easily see cashflow plummeting 20-30%. This is then a serious threat to the dividend and when the dividend is cut for a dividend stock, things get really, really ugly. 

Perhaps its time to seriously think about divesting Singtel!

The author owns Singtel.

Tangible Thoughts #1

Welcome to yet another recurring theme type of posts! Modeled after Xi Jin Ping penning down his thoughts for the Middle Kingdom after Mao and Deng, this series will pen down bite size thoughts from the great investors as well as other thought leaders.

Here's the first inauguration thought from David Einhorn taken from an excerpt of a talk he gave recently. He was asked this interesting question from the audience and his answer was just enlightening.

Audience: Do you sort of stick to your guns, when it comes to entering contrarian positions and holding it until it works out?

David: First of all, it's not about sticking to your guns. It's about reassessing constantly. And when the positions don't work, or they go against you, the presumption is not we were right, the presumption is that we might have missed something here. And so then, you have to go back and think about it again and again and again and understand the other side, and see if anything has changed, and see if your view has changed, if it has changed, to modify the position. And you might eliminate it, or you might reduce it, or sometimes increase it, but very rarely. 

Generally speaking, my inclination is when the position is not going well it's more likely that we missed something, so the choice is generally either to reduce or eliminate or just simply keep it if we think that it's right. On the other hand if we continue to think that we are right, then I find that patience is the way to go. And then we have to wait and let the story play out however it does, while we continue to reassess it to see if, in fact, we were wrong.

Investing is not about right or wrong with one's initial stance as every new development changes the course. Rather, it is about reassessing the situation constantly, changing our positions when things change or have the patience to wait for the market to realize our correct views.

Is the Virtual Economy Taking Over the World?

Here's wishing all readers a very Happy 2018! Thanks for all your support these 12 years! Today let's talk about world domination by the internet!

We discussed this topic some time back about how internet is taking over the world and real world and real life experiences are becoming a rarity. Today let's delve a bit further. We saw how the largest companies in the world are now dominated by internet firms. So, is the virtual economy taking over the world? If so, exactly how big is it really gonna be?

I think it will be almost as big as the real economy some day i.e. the virtual economy could become 40-50 trillion dollars, which is 80% of the real economy today. But it will not take over the real economy. It might be something quite different. More like an avatar economy mirroring our real economy. The real economy does not disappear, it takes on different forms while the overall pie grows.

Based on my estimate, the virtual economy today is possibly just 15-20% of the real economy today. While it did cannibalize some demand from traditional businesses, a big part of it is just new stuff. We shall see how new everything actually becomes. Now why do we say it is 15-20% today? Reference could be drawn from two data points:

1) The tech sector market cap of the top 100 firms is USD 3.6trn vs the total market cap of USD 17.5trn, meaning that tech firms make up is c.20% of the top 100 firms (according to a report by PWC).

Technology makes up 20%

2) Internet retail penetration is 15% in the US while it is 8-18% in other developed countries (18% in China). Although globally it should be closer to the lower bound since penetration in emerging countries would be much lower.

So my thesis is that from the current 8-18%, the virtual economy consisting of mainly e-commerce, content (movies, music, software, books etc) and gaming amongst other verticals will continue to grow to become 80% of the real economy. But as alluded to before, this doesn't mean that the real economy is going to shrink. This is an additional 62-72%. In other words, in x years (maybe like x = 2035) the global GDP would be USD 110-120trn and the virtual economy would be USD 40-50trn and the real economy would be USD 70-80trn. The real economy doesn't really decline, things just get moved elsewhere.

The stock market is usually very simplistic in thinking. If Amazon is taking over retail, then all the malls and related stocks should go to zero. To some extent, retail did get decimated, but because we all live in the real world, we don't stop going out. We stopped going to department stores and traditional malls but we spend more time at Starbucks, at Costco/Big Box or Don Don Donki (the new Japanese discount store in Singapore) for differentiated shopping experiences, at outlet malls, at theme parks and going for other experiential adventures. 

Costco's share price at all time high despite Amazon's onslaught

There were other interesting revelations from the content industry, namely music and movies. The music industry was the first to fall prey to the internet technological disruption. Apple Music devastated CD sales, then streaming came along and took share from music download. Now Spotify seemed to be the undisputed leader and the recorded music sales finally saw growth in 2016 after years of decline, hitting revenue of c.USD 8bn in the US. But the truth is much bigger than that. The live concert industry boomed big time from 2000 to 2016 while CD sales plummeted. In 2016, Live Nation, the world's #1 live concert operator had sales of USD 8.4bn, the bulk coming from the US. This one firm's revenue outstripped the revenue of the entire US recorded music industry! You see, things in the real world don't disappear, the revenue just moved elsewhere.

Moving on the Hollywood, with Netflix, Amazon Prime, Youtube and streaming, the first level thinking is that everyone would stop watching movies in theatres. Yet worldwide box office revenue had positive growth from 2006 to 2016. It was c.USD 9bn in 2006 and today it's close to c.USD 11bn. So did we really watch less movies? Yep, we stop watching stuff we might catch on the planes or Netflix or elsewhere but we still cherish the experience at the cinemas. We choose the one or two films we will definitely watch at the theatres.

The Last Movie of 2017

In fact, we want to watch it in IMAX. If it's the one movie we want to watch this year, then we better watch it in top quality. We pay up to watch The Last Jedi, or Avengers, or Fantastic Beast: The Crimes of Grindelwald. So the virtual economy does not take over the real economy. It is always something deeper at play. Difficult to see, always in motion, the future is.

Let's talk about gaming which is now bigger than movies and music combined. A whole generation had grown up with Nintendo, Playstation and Xbox and are now having children. With mobile gaming becoming prevalent, we are also seeing seniors playing Candy Crush and Pokemon Go! on their phones. Gaming is simply part of everyday life today. Statistics have shown that people on average spend a few hours on gaming and social media. By examining this, we might catch a glimpse of the end game for the virtual economy.

Recently Wired did a piece on the lives of esports gamers. Esports is fast becoming an important industry as gaming grew so big. For the un-initiated, esports is going to be as big as NBA or NFL or the English Premier League where teams compete in games with other teams to win championships and millions of spectators watch these pros play online. These esports players train as hard as star basketball and soccer players. They work out, study hard, eat healthy and train 7-8 hours a day playing games like Overwatch together. Yes, they spend half of their waking hours on computers, in the virtual economy.

To some extent, we all spent a lot of time online as well, since we are on laptops or PCs when we are not in meetings. We might not have enough time for shopping, gaming and/or consuming content while working but as efficiencies improve, we would be able to do much more in the 24 hours. We will be able to shop, Facebook and Whatsapp with voice recognition, maybe watch short movies on the way to the office pantry and when cars drive themselves, we free up even more time to spend in the virtual world. We will have multiple avatars for different purposes. So, yes, the virtual economy can still grow. I believe it will be 50 trillion dollars.

Does it mean we should buy FAANG and BAT now? That's a very tough question. I think there is a better time to accumulate them, rather than buying them now for 40-100x PE. Meanwhile, opportunities are abound in the real economy with great franchises trading at teens PE. These are opportunities we wish to explore in 2018 and we shall also discuss A.I. autonomous driving and semiconductor chips in the future.

Meanwhile, again a very Happy 2018, together we huat!