Sunday, June 28, 2020

Book #9: Security Analysis - Chapter 2

Security Analysis is a seminal book written by the grandfather of value investing Benjamin Graham and David Dodd, a professor at the Columbia University. It was published in 1934. I started reading it about a couple of years ago but have yet to reach Chapter 3 (out of over 50 chapters). The book has over 700 pages.

The reason for such slowness is due to the way this book was written. First, it was written by two intellects espousing difficult concepts in investing. The language they used is not common day English and it does not help that it was written over 80 years ago when the usage of English wa probably different. Nevertheless, I believe there is value in finishing this book and as I complete these chapters, I hope to jot down my learnings here.

The first lesson learnt today is about trying to model earnings trend. As it is now vs 80 years ago, analysts like to model future earnings. They could create models for the next 5 years, or the next 10 and based on their model, they believed they can calculate the intrinsic value the stock. This is also what I have done for various stocks on this infosite.

To the grandfather of value investing, this is actually bullshit. The future earnings, in their minds, are not even quantitative numbers. They are merely qualitative assumptions of the future. The way they explained it, only past financial numbers are quantitative. They are track record achieved and they provide an idea how this business can perform and how cyclical or defensive the business can be.

They look for variance in earnings, look at long term (10 years) trends and is very discerning about what is truly quantitative i.e. not disputable. I guess this is simply another verification of how Ben Graham was always looking at hard numbers, net nets and balance sheets because everything else is just qualitative.

So this is it, first lesson from Security Analysis. Hope to come back with more in the future chapters!

Friday, June 19, 2020

Thoughts #21: Venezuela

I have followed Venezuela's cautionary tale with sadness. It is a reminder to me how GFC could have crippled the world. What we see in Venezuela today is what could have happened with we screw up our financial system. Here's a quote from FT:

Nearly 5m Venezuelans have left since 2015 — about 15 per cent of the population — and another million are expected to depart this year. That could make the crisis the world’s biggest refugee emergency, surpassing Syria. Unlike other humanitarian crises, it is a disaster caused not by war or natural disaster but by misrule on a grand scale.

With GDP collapsing more than 60% and hyperinflation rendering its currency worthless, it is a broken country now with no recovery in sight. It is another reminder how commodities (Venezuela has oil and soft commodities and benefitted from the boom 2007-2012) can be the biggest curse.

Tuesday, June 09, 2020

When the COVID Wave Strikes, those Swimming in Sembawang needs Rights Issues

Warren Buffett famously said, "when the tide is out, then we know who is swimming naked". Well in Singapore today, it's rights issue buffet for companies that start with S. COVID-19 has brought down our Singapore Inc companies like dominos. We saw Hin Leong, which didn't even had a chance to do rights issue and went belly up. Then our beloved national carrier Singapore Airlines raised S$15 billion in March which was more than twice its market cap. 

Who's swimming naked?

Now, we have the Sembawang Corporation Group in trouble. More specifically, Sembcorp Marine (SMM) is in trouble. Its parent, Sembcorp Industries (SCI) and grandparent Temasek are going to save it. Not without caveat though, SCI will disown the child by giving away SMM shares to its own shareholders. But the way it is done, minority shareholders of SMM will need to cough up a lot more money to stay in the game. Yes, minority shareholders in Singapore got screwed, again!

Here's the key highlights of the proposed transaction taken from SCI's website:

1. S$2.1 billion renounceable Rights Issue 

• Sembcorp Marine to undertake a S$2.1 billion renounceable Rights Issue 

• 5 for 1 at S$0.20 per share at 31.0% discount to TERP based on 76.5% discount to last close of S$0.85 on 3 June 2020 

• Sembcorp Industries to subscribe for its pro rata entitlement of S$1.27 billion and take up an additional S$0.23 billion if necessary to a total commitment of up to S$1.5 billion 

• Sembcorp Industries will set off its outstanding S$1.5 billion subordinated loan extended to Sembcorp Marine in June 2019 to subscribe for the rights issue; the loan will convert into equity on Sembcorp Marine’s balance sheet 

• Temasek has agreed to sub-underwrite the remaining S$0.6 billion of the rights issue with no sub-underwriting fees 

2. Proposed Distribution of Sembcorp Marine shares to Sembcorp Industries shareholders 

• After the completion of the rights issue, Sembcorp Industries proposes to undertake a distribution of its stake in the recapitalised Sembcorp Marine to Sembcorp Industries shareholders on a pro rata basis as dividends 

• Sembcorp Industries shareholders will receive between 427 and 491 Sembcorp Marine shares for every 100 Sembcorp Industries shares owned, with no cash outlay 

• The transaction will result in the demerger of Sembcorp Marine from Sembcorp Industries

The chart below shows clearly how SCI will no longer own SMM after everything is said and done. Temasek will still own both entities but SCI's shares in SMM will be transferred to SCI's own shareholders. As such, SCI's public shareholders will own 30.9 to 35.4% of SMM. This effectively demerge SCI and SMM. Some say paving the way for merger between Sembcorp Marine and Keppel O&M. But, we shall see, it is never so simple.

SCI to gives its SMM shares to its shareholders

To sum things up, SCI shareholders got the long end of the stick, while SMM shareholders got screwed. SMM share price collapsed 30-40% today dropping to 50 cents at one point before recovering while SCI share price rose 30-40% to above S$2. The market verified that this is a transfer of wealth from SMM minority shareholders to SCI minority shareholders. SMM shareholders will not see their capital if they do not subscribe to the rights issue. Well, also not that high a probability if they do! SCI shareholders will get SMM shares at the end of day and get to sell them for a bit more profit. 

Similar to SIA's situation, SMM raised an amount more than its market cap. S$2.1 billion vs its market cap at S$1.6 billion-ish before the announcement. So the share price will have to more than double just to get back to where it was. During the best of times, its market cap went to S$11 billion! Barring any miracle, we can say that it will never get near that market cap. For the last five years, its market cap hovered between S$2.8 to S$3.6 billion.

Looking past the last two decades, there are almost as many years as it was free cashflow (FCF) positive as it was negative. It's so volatile we cannot even compute a FCF number. For what it is worth, the average annual FCF is minus S$700m over the last 20 years. It did make an average of c.S$250m from 2000 to 2009 but a huge negative from 2010 to 2019. In short, it's hard to justify any market cap using FCF. Well, it is a similar situation with SQ but airlines, rightly or wrongly, command a higher EBITDA multiple and fortunately for airlines, EBITDA is not FCF. 

Capex heavy businesses

Again as with airlines, the oil and gas industry is highly capital intensive, which means it is always in need of capital to drill, to grow and to compete. Look at the stuff Sembmarine needs to build (above), it sucks, time, capital, manpower. It needs land, large building and factories, permits etc. It's just not good business. To make things worse, companies like Sembmarine has to take on leverage to manufacture these rigs and ships which weakens its balance sheet. So when the tide goes out, or when shit happens, everyone is screwed. 

Once upon a time, I liked that Keppel and Sembmarine ruled the world with high market share in rigs. They got scale, they even monopolized the design of the rigs. They were riding high on high oil and gas prices. COVID-19 showed us high oil price was a mirage, something that just goes up and down. It can also go negative. Well, I guess there's a lesson to relearn here: avoid capex heavy businesses. 

So while Sembcorp Industries shareholders are laughing now, well, SCI is in the same capex heavy shit business. Building power plants and utilities is not like selling ice creams. SCI shareholders might want to think about selling out before the next wave goes in (or goes out) depending on which metaphor you like. Meanwhile, stay safe!

Huat Ah!