Merry Christmas!

2023 is coming to an end. It has been a tumultuous year with two major conflicts, blowups in the China property market and crypto going all rollercoaster. Depending on your starting point, you could have made or lost a lot. That's just investing, it's just so tough. But at the same time, regular mom and pops are having the best year in a long while just by putting money in fixed deposits and T-bills. As of this writing, we can still get 3.8% return on the SGD!

Pls do not understand 3.8%. Over time, it will still return multiple folds. Based on the table below, very roughly speaking, 3.8% return will 3x in 30 years. This is how someone used CPF to save a million dollars and more. His name is Mr Loo Cheng Chuan and he started the 1M65 movement in Singapore.

Read his blog, this is wrong one bro :)

This post also serves to update the new format we hope to drive in 2024. As our team worked on the Substack platform over the past year, we found it to be more superior and both writer and reader friendlier. As such, we hope to prioritze substack while porting what we have written over here over time.

Our Substack platform is on:

http://8percentpa.substack.com

As such, posts will first appear on Substack on every first and third Friday of the month (the team's target, but sometimes can be OTOT* also). We will periodically add bonus posts on other Fridays or if an event calls for it, a totally ad-hoc post to mark certain days of significance like today, it's Christmas!

*OTOT stands for Own Time Own Target. A terminology used in the Singapore Army during live firing at in shooting ranges. When all soldiers are in position to fire their weapons, the officer-in-charge will shout "own time own target, carry on" meaning soldiers can start to aim and fire at their targets at will. In daily life, the term has evolved to mean do whatever you want, whatever time you like and carry on with life, which is the intent and purpose used here ;)

Some of these posts on Substack are paid posts for those who are paid subscribers (USD5 per month) on Substack. Some posts will become public over time and hence shared here. The following shows the process:

• Substack paid posts and not unlockable -> only available for paid subscribers
• Substack paid posts and unlockable -> port over here over time, say 2-3 months
• Substack free posts -> port over sooner than the above
• Substack related materials like podcasts, notes etc -> port over on adhoc basis

This would really help to streamline workflow and hopefully benefit even more investors by cross-pollinating readers on both sides. Thank you for all your support all these years and see y'all in 2024!

Wishing everyone Merry Christmas and a Happy 2024 ahead!

Huat Ah!

Portfolio Strategies to Build Wealth

This article was first posted on 8percentpa.substack.com.

There is an interesting book published in 2020 called the Psychology of Money written by Morgan Housel who was a financial analyst and fund manager. He wrote about simple strategies and how wealth is best compounded over time. There is no need to complicate things and most importantly, we need to just save up and invest simply - like buying the S&P500. Then time will take care of everything else.

"Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he's been a phenomenal investor for three quarters of a century. $81.5 billion of Warren Buffett's $84.5 billion net worth came after his 65th birthday. His skill is investing, but his secret is time." 

- from the Psychology of Money by Morgan Housel

Successful investing may not be about stock picking, or following market news and trends, or all the complicated stuff the investment world likes to do. It is time and discipline, it is not making investment mistakes over that long period of time.

The following is a good quick review for the Psychology of Money:

https://sakshikumari204.medium.com/book-summary-7-the-psychology-of-money-by-morgan-housel-bb39a96558c3

While we already know all this, reading the book made me think very hard about how what we have been doing so far can be even more useful. We have analyzed more than 10 ideas, mostly stocks of companies, some mid caps, covered by analysts. Some Singapore names with little coverage, which could useful to investors in our Little Red Dot. Some really large cap, like Google / Alphabet. A lot of people have written about Google. This infosite won’t be the last to analyze Google. So, how do we make the impact most useful to our defined audience.

For some of us, like Taylor Swift, things can grow so big and the audience becomes everyone. For this infosite though, the target audience could be young to middle age adults looking to build wealth. Analyzing stocks would play only a small part. As such, we need to better redefine how to help young adult build wealth effectively.

We need simple and yet effective investment strategies.

The market is efficient. 80% of professional fund managers cannot beat indices like the S&P500 or the MSCI indices i.e. the generate less returns than market returns. Warren Buffett once said that the CEO of Vanguard, John Bogle who popularized index funds and then ETFs did more than he could ever do for investors. So investing in ETFs should be an integral part of every investor’s portfolio, especially young families’ investment portfolios.

The traditional investment portfolio starts with 60% into stocks and 40% into fixed income instruments. This utilizes diversification and has generated stable long term returns for institutional investors such as endowment funds, insurers and mutual funds. As individuals, we could also benefit from this simple strategy.

Fixed income returns are very attractive today (think short term US Treasury Bills generating 5% and Singapore 6 month Treasury Bills generating 3.8% risk free), therefore, for me, the right starting mix could be: 

• 40% fixed income with Singapore 6-month Treasury Bill as the base and then building up from here 
• 40% stocks with S&P500 ETF as the base and build from here
• 20% risk taking activities including single stocks (such as those we discussed on this infosite) and other investments

We can tweak each category to suit our own needs. If you are more conservative, you can do 50% fixed income. For some, risk taking could be 30%. To each his or her own. Let’s dive into each of these categories.

1. Fixed Income

We have spoken so much about T bills. This is just the simplest no-brainer investment today that everyone should do. In Singapore, this instrument is yielding 3.8% risk free. Simple desktop research on Google shows that the famed 60/40 investment portfolio returned c.9-10% annually over the last 25-50 years. However, it is predicted that future returns could be much lower at c.4% based on the article below.

https://caia.org/blog/2023/06/24/spectacular-past-and-concerning-future-60-40-portfolio

If so, at 3.8% per annum, Singapore T-bills can generate the bulk of the c.4% return! While I personally really like T bills (because it is risk free), there is a whole fixed income universe out there. DBS, Singapore’s largest bank, recently issued bonds at >5% and we have a slew of USD-denominated corporate bonds. But my experience with bonds had been terrible, so for now, I would simply advocated putting most, if not all, of the 40% in Singapore T bills.

2. Stock ETFs

It has been shown time and again that it is very difficult to beat the stock market. The S&P500 has returned 10%pa for more than a century. The rise of index funds and subsequently ETFs came precisely because active management wasn’t able to even just match the returns of the indices Since the first ETFs launched in the 1990s, we now have thousands of ETFs listed on various exchanges.

The largest ETFs have AUMs in the hundreds of billions of dollars and can cater for any investment need one can think of. The following shows the list of the largest and most popular ETFs and as mentioned, we have many, many more to choose from.

The following would be a list of ETFs that our team had followed and is worth doing more work on:  

• NOBL - Dividend Aristocrat 
• EMQQ - Emerging Market Tech 
• HACK - Cybersecurity 
• SOXX - Semiconductor 
• GLUX - Luxury goods

Interestingly there is little in-depth analysis on ETFs online perhaps because it entails too much effort. But this author believes more could be done. It is tedious work though. We need to run through numbers for each and every company in the ETF to come up with the valuation, free cashflow, growth profile etc. As such, our proprietary database will be available only to paid subscribers.

3. Risk Taking Activities

Hitherto our newsletter has focused on this final 20% of the portfolio. Deep analysis is at the foundation of what we do and we shall continue to publish our work on interesting companies and ideas. We hope our skills can also be put into good use by providing value added services on valuation of private companies and businesses. We will also put all the ideas into a portfolio and see how we compare against the S&P500 over time. Similarly, proprietary analysis and portfolio returns will be available for paid subscribers.

4. To sum it up

Time is of essence (albeit in a different way) and if we invest correctly based on the above, we would be compounding wealth at c.8%. Based on the table below, we can expect to slightly double our money in 10 years, more than quadruple it in 20 years and grow it 10x in 30 years. That’s unrefutable math on paper.

In reality it’s a journey. We must remember to smell the roses, spend some of it (there is no point compounding money for afterlife ;) and importantly never risk losing so much that it can bring down the house. And this is a good segue to give sneak preview on the next discussion: property. 

Huat Ah!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

Goodbye Charlie Munger

Charlie Munger, #2 at Berkshire Hathaway passed away last week at the ripe old age of 99. The value investing community exploded online with outpour of grief, past interview videos depicting Charlie's wisdom (Mungerism) and praises for this extraordinary man.

His wiki page is also well updated, which I would recommend a quick read:

https://en.wikipedia.org/wiki/Charlie_Munger

I don't think I have anything unique to praise about Munger. He is basically the best example of how we should live our lives, soldier on come what may. He lost one of his children to leukemia, was divorced, lost his eyesight in one eye, almost became blind and yet lived a full life with fighting spirit, never calling it quits.

He loved Singapore and Lee Kuan Yew, giving us praises which we may or may not deserve in many interviews over the years. Thank you Charlie. May you rest in peace!

BHP - Australia's Commodity Juggernaut

I have found that simple financials and ratios to be most useful as the first snapshot when looking at a company. This is like the first date. You are just going to see a glimpse of this person with all the excitement and risks. Is she pretty, is he handsome? What are his or her likes and dislikes? Any major dealbreaker like smoking (if you are non-smoker), drugs, violence etc. That’s simple financials. Today, we have this interesting set of numbers:

Simple financials (Jun 2023 estimate, USD)

Sales: 55.7bn
EBITDA: 30.0bn
Net income: 14.9bn
FCF: 12.4bn
Debt: 5.1bn, Mkt Cap 144.9bn

Ratios

ROE 33.4%, ROIC 30.3%
EV/EBITDA 5.2x (Jun 24)
PER 10.4x (Jun 24)
Past margins: OPM 25-45%
FCF yield 8.6% (consistently at mid to high single digit, with last two years double digits) 

This set of numbers could be the strongest we have seen so far, beating Roche’s! Alas, it is in an industry even more cyclical than Roche’s! In the lean years, it goes into losses and ROE turns negative. It is also highly capex intensive (10-35% of sales) and the firm suffered a couple of years of negative FCF over the last 30 years but only once in the past 20 years. Over the last 10 years, it has compounded nicely with share price doubling for GBP12 to GBP24 today.

Company has these great pics in its results presentation to kick off earnings discussion

Investors, skeptical of the boom bust cycles in the recent past, has ascribed inexpensive valuation across the whole sector with PER at very low double digits and EV/EBITDA at 4-6x. Meanwhile FCF of the whole industry has been exceptionally strong over the last few years.

This company is none other than BHP (used to be called BHP Billiton and before that Broken Hill Proprietary), an Australian commodity giant turned multi-national resource powerhouse. While it is dual listed in UK and Australia today, BHP provides reported no.s in USD and has been one of the strongest compounders driven by the firm’s unique competitive advantage and world class operational execution and capital management.

The investment thesis is as follows:

BHP owns some of the best commodity assets on Earth which allows for low cost production and has been able to generate ridiculously high Return on Capital Employed (slide below) and EBITDA margins of 30-60% over the last 15 years. Its management has also been able to drive further value with operational execution and capital management that has resulted in quadrupling of its book value per share from USD2 in 2003 to USD8.8 today (GBP1.2 in 2003 to GBP7.3 today).

Strong return on capital across key businesses and at the same time building new pillars for the future

The predecessors of today’s BHP have had long illustrious histories dating back to the 1800s which is worth more scrutiny for people who like to go back in time and study things. For today, let’s focus on the birth of BHP Billiton in 2001. Since then, it went through many mergers and demergers which simplified its business portfolio to focus on a few major commodities: copper, iron ore, coal, nickel and potash today.

Notably, it divested its steel business in the very early years and more recently it completely got out of energy, selling its US shale oil and gas business in 2017 and then engineering the full exit by merging the energy business with Woodside, Australia’s largest independent gas producer.

Today, BHP’s segments are clearly defined and the following chart from its 1H results briefing in Feb 2023 provides a good snapshot of the company:

Management

BHP is currently helmed by Mike Henry. He was appointed CEO in 2020 and has over 30 years of experience in resource and mining. He is supported by CFO David Lamont who was also CFO previously at CSL, Oz Mineral and other large cap Australian names. As the leading company in Australia, BHP attracts the best talent from the country to join like how Roche did as the leading Swiss pharmaceutical company.

With the best talent, strong culture of meritocracy and less politicking and bullshit, BHP continues to exhibit the positive traits of well-run companies with the right incentives and values even as it evolved into the multi-national resource powerhouse it has become today. This is exemplified by the impeccable capital allocation decisions described above.

1. Positives

Australia is blessed by the iron and mineral gods. Starting as an Australian company, the geographical advantage formed billions of years ago naturally found themselves in BHP’s portfolio, becoming part of the company’s moat. Some assets are simply legacies of the company’s history and other important assets were added by design, thanks to generations of strong, savvy management.

There are some places on Earth that provide easy access to minerals and fossil fuels. For example, Middle East is blessed with oil and gas. Africa has diamonds and gold. US has shale gas, which was made possible to extract by technological advancement. Australia has a bit of everything, iron ore, coal, minerals in abundance and they are easy to extract, benefiting BHP in the early years.

BHP’s two key assets in Australia for iron ore and coal built the foundation which it has leveraged on with efficient extraction and transportation. Then by management design, successful M&As has allowed the company to build a formidable suite of assets that enjoy high return on capital. The following lists the key assets today: 

• Western Australia Iron Ore (WAIO)
• BHP Mitsubishi Alliance (BMA) producing metallurgical coal
• New South Wales Energy Coal (NSWEC)
• Escondida, Chile (Copper)
• Nickel West, Australia
• Jansen, Canada (Potash)

In short, the first positive which is also a strong business moat is that BHP enjoys a huge competitive advantage as the lowest cost producer in its key assets as a result of Australia’s geography, which allowed BHP to own low cost mines with long lives such as WAIO and BMA. Building on this, it has gone out and acquire similar good mines and maintained and strengthened its competitive advantage across key minerals.

This solid portfolio of assets has generated supernormal free cashflow over the last 10-20 years. Cumulatively, BHP made USD168.6bn of FCF from 2003 to 2023, which is more than its market cap today. Looking back for just 10 years, it has also returned more than half of this humongous FCF amount as dividends. For an investor who bought the stock in Australia in 2013 when the share price was c.A$15 (post stock splits), the dividends distributed has more than exceeded this amount.

So here’s the second positive - BHP is simply a cash generative machine much like Pepsico was, but trading at a much cheaper valuation with slightly more volatility.

The third and last positive is BHP’s potential in Potash and Nickel. While both businesses generate negligible EBITDA today, BHP’s assets in both businesses will allow it to become a dominant player in the future as long as it continues to execute. Potash is a key mineral in fertilizers and nickel is widely used in batteries which is needed to power the millions of electric vehicles in our sustainable future.

By positioning itself with key assets that can extract these elements at low costs, BHP stands to become a dominant player in both fields when the mines come online. Both potash and nickel have also seen shortages as a result of the Russian-Ukraine war, which further improves BHP’s position. Markets like to hope and dream and given the right circumstances, share price can skyrocket into trillions of market cap if the picture of a dominant clean potash and nickel producer solving global environmental and geo-political issues can emerge. This is the upside for BHP.

2. Risks

Investing in BHP comes with three major risks: regulations, accidents and disasters and deep cyclicality. We shall discuss them below.

Regulations

In 2018, BHP settled a longstanding dispute with the Australian Taxation Office (ATO) by paying A$529m (c.USD350m) in additional taxes for the income years 2003 to 2018. The crux of the issue was related transfer pricing in its Singapore marketing arm which ATO claimed that BHP made use of to evade tax. As such, in this author’s opinion, regulations ranked as the highest risk factor. The following are the regulatory disputes from chatGPT (edited and verified to be true):

• Western Australia Iron Ore Royalty Dispute: BHP was involved in a legal dispute with the Western Australian government regarding iron ore royalty payments. This was similar to the above ATO dispute and was settled for A$250m.
• BHP admitted that it underpaid over 170,0000 days of work across the company’s current and former employees after miscalculating public holiday leave for more than a decade. The cost of remediating the issue will be c.US$280m.
• Anti-bribery Fines: In 2015, SEC fined BHP for US$25m for violating US anti-bribery law by failing to properly monitor a program under which it paid for dozens of foreign government officials to attend the 2008 Summer Olympics in Beijing.

Samarco Dam Disaster: BHP’s joint venture with Vale S.A., suffered a catastrophic dam failure at the mine resulted in a massive release of toxic mining waste, causing significant environmental damage and loss of lives. BHP faced legal actions and regulatory investigations from Brazilian authorities, leading to significant penalties and ongoing legal proceedings. More on this later.

As we can see, regulatory risk is BHP’s biggest risk. BHP’s regulatory issues are complex, recurring and has significant negative impact on earnings at times. Investors have to be mindful. Once in a while, a tsunami level issue hits and the company could be crippled for years. The mitigating factor is that BHP has managed to navigate these so far and still generate strong FCF and shareholder returns.

Accidents and Disasters

Samarco dam disaster in 2015

The second risk which is related to the above is the accident and disaster risk. In 2015, one of BHP’s asset in Brazil, the Samarco Mining Complex caused one of largest environmental damage and human tragedy when its dam broke, causing toxic mudflow to hit villages and houses, resulting in 19 deaths. BHP and its partner Vale were fined USD4.8bn. But this does not cover civil damages and the cost of recovery.

 Lawsuits are ongoing and some news articles have floated that further cost escalation to USD55-65bn for the duo is possible. Such disaster can post significant risk to commodity companies. Recall that BP’s Deepwater Horizon disaster, which was made into a Hollywood movie, still haunts the company today.

The mitigating factor is that BHP understands that safety is paramount. On the first slide of its every presentation, BHP talks about safety. BHP latest results highlighted death of one of their colleague due to accident and the CEO makes a personal message to emphasize the importance of safety. It is unclear at this juncture how big Samarco might become, but its strong share price is saying perhaps this is not going to be as crippling as it was for BP.

Deep Cyclicality

Commodity stocks are destined to be cyclical and BHP is no different. Over the last 20 years, share price have seen >50% drawdowns multiple times as we can see from the chart below. Despite its low valuations, investors will still sell commodity stocks to receive cash during market crashes in order to preserve capital. However, we also know that strong players like BHP bounce right back up and the best times to buy is when the share price has corrected significantly. Over the long run, it has also compounded value nicely and we stand to collect massive dividends along the way.

BHP has suffered a couple of huge drawdowns over the last 20 odd years: 2009, 2017, 2020 and 2022.

3. Valuations

BHP trades only at a slight valuation premium in terms of PE amongst it peers. But this can be easily justified as it is the best and the largest player. On FCF, it trades at a very palatable 9.7% FCF yield, which is ironically at a discount to industry average. Looking at its history, this seemed to be sustainable level of FCF which means that, in theory, someone should take the whole company private and reap this 9.7% dividend indefinitely.

Using our usual valuation methodologies to triangulate the fair value for BHP, we have projected FCF and Net Income at USD14bn and EBITDA at USD29bn. Applying the respective multiples give us 22-42% upside (based on the table below) which again provides enough margin of safety. I would argue that these no.s also err on the conservative side. 

Lastly to ascertain the risk reward profile, we first look at the share price movement of the last 10 years. While a 50% drawdown has happened before, this brings its FCF yield to c.20%. Although it is possible, I would put it as unlikely, and if it happens, management or some deep pocket buyer would simply take the company private. As such, a bear scenario with 30% drawdown seemed more reasonable. The upside scenario, as alluded in the valuation above is 42%. So with that in mind, the risk reward for BHP seemed balance at -30% to +42% but with the potential go up much higher given its history of strong FCF generation, dividends and simply compounding returns.

Podcast - Nov 2023

This podcast was first recorded for 8percentpa.substack.com during the end of November. 

We discussed the impact of global inflation and its impact to our portfolio and also our lives. he link is as follows:

https://8percentpa.substack.com/podcast

Please see the transcript below:

***

Welcome to the second podcast on 8 Percent Substack. Thank you for listening and we hope to provide you with insights to help you manage your personal finances. 

In this podcast, we will discuss the impact of global inflation to our portfolios and our lives. Most of us would not remember inflation because it did not happened in a big way since the 1990s until 2021-2022 which is about 2 years ago.

Prices of products and services have been kept low as China was making everything cheaply and exporting them. Toys, clothes, everything!

Some corporate services such as IT management and call centres were also being exported out of India. 

And lastly migrant workers have also kept service costs low. They worked hard as waitresses, hairdressers, security guards. Thank you!

In sunny Singapore, we did have inflation but it was by and large manageable.

But, things changed dramatically during the pandemic and is now further exacerbated by wars, rent and salary inflation.

The pandemic disrupted global supply chain and caused prices to increase in a big way. The Russia-Ukraine war then caused energy prices to spike and now with another war in Gaza, we will see further disruption.

In sunny Singapore, rent and wages are spiralling up. When rent goes up and wages go up, businesses need to charge consumer more, this means things will get even more expensive.

The saving grace is that cash can also earn interest today as the US Fed has been raising interest rates to tame inflation.

Since Singapore largely follows the US, we are seeing our fixed deposit rates and Treasury Bill rates going up.

$100 invested in Singapore Treasury Bills earns almost 4% interest today.

People who have saved money can benefit tremendously from this. We were taught to save up in school. 

Remember the adage: Save Up For Rainy Days. 

This is now really helping, albeit in a different way!

At the same time, people with a lot of debt and lower income households are experiencing hard times. It is not easy for them.

Another old adage comes to mind, always be prudent because sometimes it doesn't just rain, it pours.

In the next podcast, we shall discuss more on this!

Thank you for listening. See ya!

***

Roche - Europe's Pharma Gem

This post first appeared on 8percentpa.substack.com

Healthcare has always been a strong return generating sector and has consistently beaten the broader stock market. According to data from the S&P 500 Health Care Index and the S&P 500 Index, the healthcare sector has outperformed from May 2001 to May 2021. with an annualized total return of 12.1%, which was higher than S&P 500's annualized total return of 7.4% during the twenty year period. 

I have monitored Roche for a couple of years and admired its strong cashflow compounding and drug innovation prowess. In the last twelve months though, the share price underperformed on the back of the dismal outlook of European stocks and Roche’s lack of growth as it faced declining revenue from the fallout of COVID-19 related sales. As such, share price corrected from CHF400 to CHF240 today, a c40% drawdown. This presents an interesting opportunity to buy the stock today. 

At USD320bn, Roche was the largest European pharmaceutical company by market cap when Visual Capitalist charted the above. Today, it is #2 behind Novo Nordisk (market cap >USD400bn) with its market cap USD220bn as of Oct 2023. That said, Roche is consistently ranked top 5 globally in the pharmaceutical space either by revenue or earnings. As per previous ideas, we shall discuss its investment thesis, moats, risks and valuation in detail today.

1. Investment Thesis

Founded in 1896, Roche is one of the oldest pharmaceutical company around with strong innovative roots and was the pioneer in tranquilizers, antiviral drugs and cancer treatment or in today’s terminology - oncology. Fast forward to the 2000s, it made a series of good acquisitions and has now grown into a Swiss multi-national healthcare giant with two core divisions: Pharmaceutical and Diagnostics. 

Roche’s investment thesis is predicated on the following: 

 

1. Diversified portfolio of strong innovative drugs: Roche has built a robust portfolio of innovative drugs in oncology, immunology, and neuroscience. On top of that, the company also has strong research and development (R&D) capabilities which has regularly churned out blockbuster drugs such as Avastin and Tamiflu. 

2. Leading position in diagnostics: Roche is a market leader in the diagnostics industry with a wide range of products that are used in laboratories worldwide. This business consistently generate c.20% of overall EBIT over the last decade. 

3. Roche is a free cashflow generating machine: In 2000, Roche generated c.CHF1.5bn in FCF. It has steadily compounded that and today’s FCF is 10x of that. Its dividend shows the same story. 

As usual, we also have Roche's simple financials and ratios below:

Simple financials (Dec 2023, USD) 

•  Sales: 66.9bn EBITDA: 25.6bn 
•  Net income: 15.0bn 
•  FCF: 16.5bn 
•  Debt: 18.2bn, 
• Mkt Cap 218.5bn 

Ratios 

•  ROE 47.3%, ROIC 24.4% 
•  FCF yield 6.2% (consistently at mid to high single digit) 
•  EV/EBITDA 8.9x (Dec 24) 
•  PER 11.7x (Dec 24), PBR 4.6x (current) 
•  Past margins: OPM 25-35% 

Roche’s numbers could be the strongest we have seen so far in the past few ideas. This corroborates with what we discussed earlier: the healthcare sector has consistently outperformed the broader market and this is because it enjoys stronger margins and return profiles due to the nature of its business. With ROE and ROIC above 20%, but PER at just teens, it simply shouts cheap!

The numbers in the simple financials are translated into USD for easy reference. But Roche actual disclosure in Swiss Franc (CHF) is actually super transparent and it breaks down its businesses in detail for whoever is interested to dig. The slides above give the high level picture while its latest annual presentation materials contained 200 more pages in the link below:

 https://assets.cwp.roche.com/f/126832/x/5738a7538b/irp230202.pdf

M&A

Roche has had a long history of M&A that accelerated in the 2000-2010s and made the company what it is today. In the earlier years, one of the more important acquisition was that of Biomedical Reference Laboratories in 1982. This acquisition helped built the foundation of Roche’s diagnostics business in the US. 

 In 2002, Roche bought a stake in Japanese pharma company Chugai and raised its stake to c.60% in 2008. The overall amount that Roche paid was c.USD2bn but its stake today is worth c.USD30bn, making Chugai one of its is most successful purchases. 

Thereafter, Roche made a series of important M&As: 

1. Ventana Medical Systems for USD3.4bn in 2008, which further strengthened its diagostics business.
2. Genentech for USD46.8bn in 2009, Roche’s largest acquisition ever. Genentech is considered to be the first biotech company. 
3. InterMune for USD8.3bn and Seragon Pharmaceutical for USD1.7bn in 2014, both biotech companies focusing on orphan diseases and cancer treatments respectively. 
4. Spark Therapeutics for USD4.8bn in 2019, a US based gene therapy company. 

These successful bolt-on acquisitions strengthen the company, allowing them to gain market share and receive new technologies, talent and knowhow. The company is also very smart in the way they do it. For both Chugai and Genentech, Roche started with a small stake to know the partner better before acquiring more, thereby ensuring that the integration will be smoother. Roche’s prowess in M&A became its weapon to both beat the competition and absorb smaller competitors for its own benefit. 

2. Business Moats 

As a pharmaceutical company, Roche enjoys a few moats not available to normal companies. The most important of which is patent protection. Pharma companies are in the business of discovering new drugs and when they do, they file patents and enjoy good economics for 15-20 years to sell these drugs profitably. In fact some companies exploited this and charged an arm and a leg for orphan drugs which led to other issues. But the bottomline is that patent protected drugs make money and Roche has 15-20 of these blockbuster drugs across oncology (cancer), immunology, infectious diseases and other segments at any one time. 

That’s Roche’s first moat - patent protection. 

 The second moat is its R&D engine combined with scale and results. As mentioned, Roche has consistently churned out blockbuster drugs and looks like it will continue to do so. R&D alone is pretty worthless but with scale, it becomes a huge barrier to entry. Roche spends more USD10bn on R&D every year and there are only a handful of companies that match that. The following list comes from chatGPT: 

 Based on cutoff in September 2021, the following are some of the top pharmaceutical companies known for their significant research and development (R&D) budgets, based on their reported spending in USD. Please note that rankings and budgets may have changed since then: 

1.  Johnson & Johnson: R&D budget of approximately $12.2 billion (2019). 
2.  Pfizer Inc.: R&D budget of approximately $8.1 billion (2020). 
3.  Roche Holdings: R&D budget of approximately $11.4 billion (2020).
4.  Novartis International AG: R&D budget of approximately $10.5 billion (2020). 
5.  Merck & Co., Inc.: R&D budget of approximately $11.3 billion (2020). 
6.  Sanofi SA: R&D budget of approximately $7.9 billion (2020). 
7.  AstraZeneca PLC: R&D budget of approximately $6.6 billion (2020). 
8.  GlaxoSmithKline PLC: R&D budget of approximately $5.1 billion (2020). 
9.  Eli Lilly and Company: R&D budget of approximately $6.0 billion (2020). 
10.  Bristol-Myers Squibb: R&D budget of approximately $5.9 billion (2020). 

ChatGPT is awesome! 

R&D dollars are table stakes in the world of pharmaceuticals. If you cannot cough up a few billion dollars to do research in finding new drugs, there is no business to talk about. Naturally, the bigger the budget means more research being done, more money to hire better talent and higher chances of finding blockbuster drugs. With the second highest spending and more than twice as big as #8 (GSK) and below, Roche is playing in the big boys league. 

Besides being big, Roche’s labs were also efficient and were able to continue to churn out new drugs and allowed the firm to manage patent expirations very well. This proved that its R&D dollars were well spent, there are always results to show for and that attracts the best scientists to work for Roche and ensure that their labs continue to be successful. They even have the best R&D labs (pic below)!

With good R&D and clout in the Pharmaworld, Roche has also built an eco-system of doctors, drug specialists and medical reps who helped it distribute its drugs efficiently across the globe. This is an intricate system that takes years to build and nurture. When a key drug goes off patent, generics can come in but Roche is able to combine its off-patent drug with another drug and keep selling the combination to doctors who would recommend it to patients, thereby delaying generics from gaining market share quickly. 

This is the same moat as the distribution network that large FMCG companies like Pepsi has. It is not easy to replicate. With such moats, it is no wonder that Roche enjoys double digits margins and ROICs. But what are the risks? Every investment comes with risk and no matter how good things look, there is always an Achilles’ heel somewhere. Just like how every superhero has his or her nemesis and Superman has to deal with Kryptonite. 

 3. Risks 

Stagnation 

At Roche’s current juggernaut USD220bn in market cap, it gets harder and harder to grow and the company’s recent no.s are showing that. There is no meaningful growth over the last few years despite the supposed boost from the pandemic. Roche provided those ART test kits we used and a slew of diagnostics related to COVID-19 but that was offset by patent expirations and at the corporate level, we are just seeing the modest growth as shown below. 

Lawsuits and regulatory risks 

Pharmaceutical companies are prone to being sued and Roche had its fair share of lawsuits over the years with its key drugs like Avastin, Tamiflu and vitamin pills alongside other pharmaceutical companies. In a landmark lawsuit, Roche paid a record USD500m criminal fine for leading a worldwide conspiracy to raise and fix prices and allocate market shares for certain vitamins sold in the United States and other parts of the world. The conspiracy lasted from January 1990 into February 1999 and affected the vitamins most commonly used as nutritional supplements or to enrich human food and animal feed. 

The full press release below: 

 https://www.justice.gov/archive/atr/public/press_releases/1999/2450.htm 

 As such, regulators are constantly watching Big Pharmas. Regulations can always screw pharma companies. Besides fines, it could be cease and desist orders on their production facilities, or it could be price caps on drugs that are too profitable. After all, if the umpire is not doing his job, then game hell breaks loose. For Pharmaworld, Purdue Pharma and Oxycontin comes to mind. That said, Roche has definitely managed these risks better than some peers and there has not been multi-billion fines or lawsuits against the company as far as I can tell. 

Breakup 

One idiosyncratic risk with Roche is the dissolution of its current structure housing diagnostics and drugs under one entity. Roche is the only pharma company having such a unique structure and it is not inconceivable that some activists ask for a breakup or some other kind of financial engineering to “create value”. While monetary gains could be made ultimately, it is straining on management resources and with Swiss pride and ego involved and one can imagine how volatile Roche share price can gyrate. We could see more 30% drawdowns, which is not what investors want. The mitigating factor is that at current share price, Roche is already cheap and I don’t think the downside would be big even if there is some negative newsflow on this issue. 

4. Valuation 

As with the previous analysis, I have used excel to triangulate valuation using Free Cashflow, Enterprise Value and Price Earnings. The Earnings column refers to free cashflow, EBITDA and Net Income respectively and we slap the multiple on for each metric. In analysis done earlier this year in the original substack post was pretty off. Jsut to give you a flavor, the following shows the downside case we had, today, Roche's share price had completely crashed through this and now trades at CHF240.

This is a good segue to discuss that a lot of our investment decisions will be wrong. The best investors are right 57% of the time. Not alike how the best baseball players only have batting average of 0.3 and batting average of 0.4 is considered unachievable. That means the best baseball players cannot hit 4 out of 10 balls thrown to them. In similar fashion, the best investors get 43% of their trades wrong. So, we were wrong, earlier in the year and the new valuation of Roche perhaps looks like the following:

Over the last 20 years, Roche has suffered 40% drawdown during the GFC while most other drawdowns ranged from 20-30%. Perhaps this higher volatility explains the valuation difference with Pepsico but it also represents the opportunity today. The above shows the implied valuations are taken down by a few turns to reflect peer valuation, which was the mistake we made earlier. For comparison, European pharma names trade at one year forward PER between 14-28x. Novartis is at 14x, AstraZeneca at 18x, Merck at 15x and Novo Nordisk at a whopping 30x. Pfizer trades cheap at 10x though. If we take a simple average, we are looking at 17x. So putting Roche at 15x probably makes more sense.

 Intrinsic Value (IV) 

To calculate Roche’s intrinsic value, we would simplistically use PER today. Using 15x above, Roche’s IV will be c.CHF320 and this represents c.33% upside from today’s price. I would think that this provides good margin of safety at current prices. The stock is cheap. To reiterate, Roche's IV was off in the original post. We had Roche IV at CHF380. It could get there if things changes. But for now, CHF320 looks more right.

Lastly on dividends, the chart above shows how Roche has increased dividend for 36 years consecutively. We also get to earn CHF9.5 in dividend representing a c.4% dividend yield which should continue to grow given the track record. Therefore, Roche as one of the best healthcare bet that plays on the global growth in demand for better drugs in oncology, immunology and neuroscience and better diagnostics with a demonstrated track record in compounding earnings over decades, will be an attractive European compounder to own in the portfolio. 

Huat Ah!

Charts #50: More on Property - Offices

The pandemic upended offices with vacancy rates hitting all time high in some cities as the chart below shows. This has impacted property valuations and changed the landscape for entire vicinities.

Interestingly, it also reflects work culture in different parts of the world and different industries. Asian workers tend to head back to office while tech startups are resisting. 

But if we can stretch on the horizon, we should revert to norms over time and therefore it might be a good time to start buying office reits now!

Pepsico - FCF Generation Machine

This post first appeared on Substack a few months ago.

The human brain is weak. We are wired to succumb to temptations easily and we slide down slippery slopes and are unable to get back on our feet without tremendous effort. That is why it is so hard to lose weight, or stop swiping those TikTok videos or quit drinking or smoking. The common denominator for the above question is addiction. We just cannot stop ourselves when our brains from crazy over those dopamine hits. No pun intended but we are, in essence, not too different from zombies always going crazy for brains. They also cannot help it.

Businesses that leverage on this weakness become cash generating machines as consumers cannot stop consuming their products. Think sugary drinks, addictive games, new seasons of Game of Thrones and salty snacks. It gets so bad that governments have to clamp things down. Cocaine is illegal in most countries as with most drugs. 

Many countries has imposed sugar tax and China restricted kids from playing games after 10pm. But that does nothing to stop these companies from churning cash because people simply cannot stop themselves from wanting more. They will still consume even if you raise prices, reduce the volume per pack or even reduce the quality of the product.

Our idea today is one such consumer company with market cap of over USD250bn, which is roughly the size of New Zealand’s GDP and almost twice the size of Ukraine’s GDP and amazingly, a tad smaller than our Little Red Dot’s GDP. We shall discuss its investment thesis, moats, risks and valuation.

The investment idea today is a compounder and a household name which I have followed for a decade as an analyst but its brands are brands I have known all my life, as I am sure most of us do. We will be discussing Pepsico (Ticker: PEP), listed on the NYSE. The stock has compounded tremendous growth for the past 40 years.

1. Investment Thesis

Pepsico is the world’s largest potato chips manufacturer and the world’s second largest bottled soda drink maker behind Coca Cola. The company has a diversified portfolio of iconic brands such as Pepsi, Frito-Lay, Gatorade, Quaker Oats, and Tropicana, among others that creates great products which are well-liked because they are savory and addictive. It has also built a strong global procurement and distribution network in 200 countries on the back of its sheer size as one of the leaders in these two consumer sectors which provides Pepsico huge competitive advantages against smaller competitors.

Today, Pepsico ranks amongst the top 5 global FMCG (fast moving consumer goods) companies and has compounded growth at minimally high single digit pace for decades. In the recent 5 years, share price has also more than doubled from c.USD80 in 2018 to c.USD180 today. The following is Pepsico's simple financials and ratios:

Simple Financials

• Sales: 89.9bn 
• EBITDA: 16.3bn 
• Net income: 9.7bn 
• FCF: 8.3bn (current FCF in 2022 is 5.6bn) 
• Debt: 36.1bn, Mkt Cap 253.9bn

Ratios

• ROE 53.7%, ROIC 16.2% 
• EV/EBITDA 16.5x (Dec 24)
• PER 23.4x (Dec 24)
• PBR 14.5x
• Past margins: OPM 14-18%

Management

While Warren Buffett did famously say (below) it is not about management but more about the business, it is worth mentioning Pepsico’s previous and current CEOs. Pepsico’s success over the last two decades can be largely attributed to Indra Nooyi, who served 12 years from 2006 to 2018. Her Spanish successor, Ramon Lagurta took over well and has continued to drive growth. What Indra and her team did was both strategic and effective.

“ When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. ”

In the years prior to becoming CEO, Indra was CFO and SVP for corporate strategy and she famously spun out Yum! Brands which was Pizza Hut, KFC and Taco Bell. These restaurant businesses did not fit well with Pepsico’s core products even though conceptually they were supposed to fit back in those days. Since you sell carbonated drinks, why not own businesses that sell those drinks day in day out? Today we know that it doesn’t work. Indra sold those businesses and bought Tropicana and Gatorade which further strengthened Pepsico’s distribution network and its business moat.

Next, Pepsico reclassified its products into three categories: "fun for you" (potato chips and regular soda), "better for you" (diet or low-fat versions of snacks and sodas), and "good for you" (oatmeal). It was easy to understand and put Pepsico in a good light as the world moved to emphasize on ESG. Her legacy continues today as her successor continue to grow profits and dividends.

2. Business Moats

Buffett also said the most important thing about businesses is how they defend their market share. He coined “Business Moats” as the term to illustrate characteristics of strong companies that would help fend off competition. For the fun of it, I asked chatGPT, “What is Pepsico’s business moat?” and the following is what it churned out:

Pepsico's business moat is primarily built on its strong brand recognition and extensive distribution network. As a leading global food and beverage company, PepsiCo has a portfolio of well-known brands such as Pepsi, Lay's, Gatorade, Quaker, Tropicana, and Doritos, among others, that have become household names.

Additionally, PepsiCo has a diversified product portfolio spanning snacks, beverages, and other food products, which helps it to maintain a stable revenue stream in different market conditions. The company also invests heavily in research and development to create innovative and sustainable products to meet changing consumer preferences.

Moreover, PepsiCo's extensive distribution network, which includes partnerships with bottlers and retailers, allows the company to reach customers across various geographies and demographics. This distribution network provides the company with a competitive advantage over smaller players who may not have the same level of reach.

Pepsico is committed to operating in a socially and environmentally responsible manner and has demonstrated ESG leadership. The company has set ambitious targets to reduce its environmental footprint, improve the lives of farmers and communities in its supply chain, and promote diversity and inclusion in its workforce. These initiatives not only benefit society but also position PepsiCo as a responsible corporate citizen and a leader in the ESG space.

Overall, PepsiCo is a well-established company with a strong brand portfolio, diversified revenue streams, and a commitment to ESG leadership. These factors, combined with its consistent financial performance, make PepsiCo a compelling investment opportunity for long-term investors looking for exposure to the food and beverage industry.

I must say this is really not bad! It picked up Indra Nooyi’s ESG leadership point as well! But alas for serious value investors’ deep dive, chatGPT is still not good enough. Maybe we can give it a few weeks and open access to Substack, after some more learning it’s game over for writers like us :)

Okay, before that happens, let’s get back Pepsi’s moats. ChatGPT got the two most important moats: brand and distribution. Brand is easy to understand, humans like familiarity and if businesses can deliver consistency, consumers will just keep coming back. Starbucks, Johnson and Johnson, L’Oreal, LVMH, Macdonald’s, Toyota, Singapore Airlines and Yakun Kaya Toast all built their businesses on consistency and reliability.

Distribution is key and towards the consumer, it is about securing shelf space in retailers, being able to restock products as soon as they run out, putting the right products in front of consumers in the right season. Drinks in summer, chips before big games. It is also vital in procurement. Get suppliers globally, procure at low costs but ensure consistent supply. Frito Lay became the largest potato chips maker because it can secure potatoes from growers all over the world. As it grows in size, it becomes harder and harder for others to secure potatoes and even if they do, competitors cannot buy at the same low price.

This is economies of scale at work. Frito Lay can procure potatoes cheaply because it has volume. This is the same for all other raw materials: packaging, PET bottles, syrup, oats etc. It can also secure shelf spaces cheaply, it then has more marketing dollars to spend, ensuring mind share with consumers.

Economies of scale → lowest cost producer → higher gross margins → more marketing spend → bigger market share

There is also a strong positive cashflow angle. Pepsico can always have better payment terms. It pays farmers some small upfront cost to grow potatoes. It pays distributors deposits to put its chips and drinks on shelves. These are cents per packet or per bottle. But when the consumer buys a packet of Ruffles at $5, the money goes to Pepsico fairly quickly because its systems are linked with retailers like Walmart and Costco. If we buy on e-commerce, then it gets money instantaneously. So Pepsico’s working capital cycle is very short. In fact, in 2022, it was negative. It was -USD6bn against revenue of USD90bn. Pepsico’s upstream supplier and downstream counterparties funds its day-to-day business operations.

As the company keeps improving its margins and cashflows, Pepsico realized it doesn’t really need a lot of equity on its balance sheet. So it kept buying back its own shares. ROE hit more than 50% since 2016. I believe there is room to further improve ROIC (c.16%) as well. It used to be just 27%! This is the beauty of FMCG businesses or in general, businesses with good economics.

3. Risks

Every investment comes with risk and we need to understand them well and see if there are any mitigating factors. Most of the time, risks can be mitigated if we buy cheap enough. For a name like Pepsico, the ability to compound also helps. It is akin to the current environment when risk free rate is 4%. If you lost 10% on some investment, cut loss and put in T-bills, you get it back and a bit more in 3 years. But with Pepsico, you just have to wait for compounding to do its work.

Anyways, let’s go through some of its key risks:

Market correction / valuation compression

As valuations are not cheap (25x PER and 18x EV/EBITDA), Pepsico and similar companies are vulnerable to any kind of market correction. Hedge funds, institutional investors will sell large, liquid and expensive names which in the past has caused 25-30% drawdown for Pepsico. This, in my opinion, is the biggest risk because it will take 4-5 years of compounding to clawback negative 25-30%. But if it falls that much, also means it will be a good opportunity to accumulate if the other risks listed below are non-issues.

Competition

This is another good point picked up by ChatGPT although its explanation was not good enough. Pepsico is constantly bombarded by competition. Arch-rival Coca Cola will not stop hammering at Pepsi’s drink business and in this new economy, there are endless shelves on Amazon and so part of its moat of having good distribution to supermarkets and good bargaining power for shelf space has become mooted. There are also new niche brands coming out every other day. Singapore’s own Dangerously Addictive Irwin’s Fish Skin and Potato Chips made such a big splash in the local scene in a few short years. You can imagine globally how many niche brands are chipping away Pepsico’s shares in both snacks and drinks.

Of course the mitigating factors are also spelt out above. Pepsico will enjoy lower costs, cheaper marketing dollars and a lot more resources to crush anyone because of its scale. Pepsico can just buy Irwin for USD250m tomorrow, which doesn’t move the needle at its USD250bn market cap and *poof* this competition is gone.

Regulations

Large companies are always vulnerable to regulatory risks and Pepsico, with its addictive sugary drink and salty snack portfolio is always in the cross-hairs of regulators’ firing squad. In the ten years from 2012 to 2022, a slew of countries passed sugar or soda tax laws to reduce consumption of sugary drinks because it became medically proven and established that sugar causes diabetes. Similar to tobacco taxes, this was argued to be good for humanity. Pepsico’s share price reacted negatively whenever announcement of countries passing the such tax bills hit the newswire. But compounding has since done its magic and it is not longer talked about today.

However, regulatory concerns will continue and in today’s context, extensive use of plastic and PET bottles could be targeted. Or anti-competitive moves could be picked up by the authorities. Lawsuits can also hit share prices. Johnson & Johnson was recently hit by Talc baby powder lawsuits (which we all used!) but a quick search will show it had been hit so many times in so many different products over decades.

While most companies survive such sagas, once in a while, we see companies falter and unable to recover. Recent examples not in the FMCG industries such as Bayer and BP come to mind. We just have to be mindful that this is part and parcel of investing in large prominent companies.

Poor execution

Highly cash generative companies can be more prone to execution risks because they are constantly being asked to distribute the cash back to shareholders if they have nothing better else to do with it. As such, management find it irresistible to buy things. Doing M&A is fun, you meet other companies senior executives, wine and dine with investment bankers’ money, get to travel and just in general being viewed internally as doing something transformative. But we also know that c.60% of all M&A fails and companies get saddled with debt.

Gladly, Pepsico does not have this problem for now. It has done very good M&As and it has also returned a ton of money to shareholders. We have a chart further below showing that the company executed 51 years of consecutive dividend hikes. Gosh, that’s more years than yours truly has spent on Earth.

4. Valuation

Today we will use four valuation methodologies (FCF, EV, PER and Dividend) to triangulate (or quadriangulate) the range of intrinsic value for Pepsico. I have complied the table below for easier digestion. The earnings line is essentially FCF, EBITDA, Net Income and Dividend multiplied by 8% growth (one year forward) for the four methodologies respectively.

Multiples are always the hardest and I have not done a lot work to justify the numbers above. I just looked at the recent numbers used them. As we can tell, the upside is limited and this would not past Buffett’s margin of safety test. Adjustments are done for EV to add back debt and for Dividend to add this year’s announced dividends. Intrinsic value is in per share terms and upside is calculated using the share price today is $185.

With the power of Excel, I also did a quick sensitivity test above and I brought down all the multiples above by 5 points and we have the new intrinsic values showing between 9-18% downside. .

Recall that Pepsico has suffered maximally 30% drawdown in the past, which we should not expect in most normal circumstances. So at 9-18% downside, I would say these no.s represents good downside cases. As such the risk reward is essentially minus 9-18% vs compounding at 8-10% annually which is had done i.e. 80-100% upside over my investment horizon of 5-7 years. This is good risk reward in my opinion, but I would want that margin of safety. Let’s see how we get there

Intrinsic Value

Just using simple math, I would take the average of the four IVs above which brings Pepsico’s IV to c.$210 and this represents c.14% upside from today’s price. In order to get 30% margin of safety, I would think that the right entry price today should be c.$150-160. For full disclosure, my average price is closer to c.$80 many years ago. But at $160, I will be buying more. .

To sum it all up, Pepsico is one of the world’s best compounder with strong core businesses in addictive products such as sugary drinks and savory snacks. The following chart says it best. According to Google, Pepsico’s share price was $2.08 this month in 1983, some 40 years ago. So if we bought then, the dividend we get this year is more than double our capital and our capital gain is 170x

Huat Ah!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

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Notified works with more than 10,000+ global customers, from growing businesses and new IPOs to some of the world’s most recognizable brands. With a suite of world-class, award-winning communications solutions, Notified provides its clients the relevant tools to effectively reach and engage customers, investors, employees, and the media. With the partnership our infosite can also now leverage on this platform to share news and updates!

Huat Ah!

SGX

This post first appeared on https://8percentpa.substack.com/p/investment-idea-5

Exchanges are the core hubs of financial activity when it comes to stocks, shares, some traded bonds and in today’s context, ETFs, derivatives and a suite of financial instruments As such, today’s idea is another Singapore company that has built its business as the electronic trading marketplace for stocks, bonds, derivatives and other financial instruments. 

The Singapore Stock Exchange or SGX is Asia’s most international multi-asset exchange and is one of the most profitable companies in the Straits Times Index with operating margins at c.50% and ROE at c.30%. It has been a phenomenal compounder since IPO. It started trading at 30c back in 2001 and the share price today is $9 and its market cap is slightly shy of SGD10bn while its revenue topped SGD1bn for the first time in 2021.

1. Fundamentals

SGX, like many other global exchanges which are highly profitable, trades like a start up with its market cap at c.10x of its revenue (i.e. c.10x Price-to-Sales) but it is justifiable because profits are ridiculously high. The key difference: startups at 10x Price-to-Sales are usually still in red. They are selling a concept, a dream. Exchanges have made those dreams reality, churning out crazy profits. Importantly, valuations based on earnings, as we shall see later, make sense. We will also compare across different exchanges, they are all drowning in profits. 

Why are exchanges so profitable? 

First, the business has no cost of goods sold. The platform provides the venue for buyers and sellers to transact. There is some cost but it is negligible compared to a manufacturer requiring raw materials or airlines requiring heavy investments to buy airplanes. Furthermore, when the platform establishes itself as the venue of choice, naturally it attracts more buyers and sellers. Like grocery stores and marketplaces, exchanges are about connectedness. The more you connect market participants, the more others will want to join. In financial markets, this translates to liquidity, the ease to buy and sell shares, bonds and other financial instruments. If you wanted to buy shares of Singapore Airlines, well, the Singapore Stock Exchange is most liquid exchange to buy from and for some retail investors, it is also the only place to get those shares because they do not have global brokerage accounts or are simply not comfortable to buy the depository shares or receipts on other exchanges. 

This brings us to the second point. Exchanges are also monopolies. At the height of the FAANG boom, if you wanted to trade the FAANG* stocks, the natural venue is NASDAQ. Before that, if you wanted to trade the cool China internet names or industrial names during China’s boom in 2003-07, you got to go to the Hong Kong Stock Exchange and in the 1980s, if you wanted Japan exposure, there is only the Tokyo Stock Exchange. Singapore stocks do not have the same drawing power but the SGX team has more made up for this shortcoming by targeting very niche instruments and becoming the marketplace for trading such instruments. 

To list a few examples, SGX today has positioned itself to be the exchange for commodities like iron ore, rubber, some petrochemicals and certain types of forex and futures derivatives. In the past, SGX was also a pioneer in launching REITs and ETF products in Asia and continues the lead today with a large number of listed REITs and it recently established itself as one of Asia’s largest international trading venue for Chinese fixed income ETFs.

Building on core bases such as fixed income and cash equity trading and clearing, securities settlement and depository management, SGX has also branched into the indices and connectivity (co-location) businesses, which provides market data and collects licensing and subscription fees, which forms the base of its recurring revenue. This helps to reduce the volatility of earnings as these businesses are less impacted by market volume. By my estimate, recurring earnings from such operations contributes c.25% of overall profits and will continue to grow (see segment information above). 

The crux of the exchange business is also its scalability on the same platform with very little additional overheads required when growing revenue. This can drive supernormal profits thanks to the proliferation of electronic trading. Trading systems are not as expensive as banking systems and capex intensity is very manageable at c.3-4% of revenue (c.SGD30-45m). Additional trades simply create revenue that drops straight to profits. For banks, their systems need to handle ATM withdrawals, cross-border money transfer, fraud detection which incurs a lot more costs.

Besides systems, SGX has labor cost as the other big cost component, as with most other exchanges. It employs c.1,200 people and pays out c.SGD240m in salaries. There is also processing costs and royalties but those are smaller compared to IT systems and salaries. The end result is this high margin (OPM at c.50%) cash generating machine churning out almost half a billion in net profits which is almost fully paid out as dividends annually.

This story is the same as we look across global exchanges:

SGX is also highly free cashflow (FCF) generative. It only had a single year of negative FCF in 2001 when the dotcom bubble burst. Since then, the company made c.SGD300-600m of FCF annually over the last 10 years which it is mostly paid out as dividends to shareholders. The largest beneficiary of which is Temasek, which owns 23% of SGX and therefore receives SGD60-120m annually which has more than covered the original investment cost after collecting this amount for the last many donkey years and yet the stake is still worth c.SGD2.3bn today. 

*FAANG was the acronym for the hottest internet stocks from 2015-2022: Facebook, Apple, Amazon, Netflix and Google, before Facebook and Google changed their corporate names to Meta and Alphabet respectively.

Risks

Is it too good to be too profitable? The affirmative answer to this question is one of the key risk for SGX. When the company has money coming out from its ears, management simply cannot resist the urge to spend. Over the last few years, SGX spent more than half a billion dollars buying companies and goodwill on its balance sheet is now SGD708m which is c.45% of its equity. If this is impaired, the share price would collapse. 

The second risk is competition and how can SGX stay relevant. As alluded above, Singapore is not Hong Kong or NASDAQ and we do not have sexy stocks or sectors that can drive investors to come to trade. The SGX model is built diligently on niche markets which could simply migrate elsewhere tomorrow. SGX’s management knew this and desperately wanted to create stronger business moats. In 2011, SGX tried to make a joint bid for the London Metal Exchange (LME) after failing to acquire ASX, the Australian Exchange. LME was ultimately sold to SGX’s arch rival HKSE for c.USD2.2bn.

It is difficult to say if SGX have strong moats around its niche instruments. The mitigating factor is that SGX has managed to grow its revenue steadily from c.SGD200m in 2013 to more than SGD1bn today. In some ways, the SGX growth story draws parallel with Singapore’s own story. We have nothing yet we built a modern city state that thrives on efficiency and effectiveness. Things just work and foreigners loved it! Now Singapore is well-known as a global financial hub and that has contributed to SGX’s moat directly.

2. Technicals

Despite the strong business model, SGX’s share price has gone through a roller coaster ride during the pandemic. It rode to a $11 high and then dropped almost 1/3 to $8 and is now closer to $9 today. The main reason could be the dividend, which wasn’t increased when everyone expected them to do so for FY ending Jun 2023. The other could the risk that we discussed above, the company is squandering away the money into bad M&As. 

For the above reasons, share price is not too far from the pandemic low of $8. Recall that this is a level at the height of global pandemonium during covid and market participants capitulated. The most bearish sellers sold out and the stage is cleared with all selling pressure abated. As such, prices then (around Mar 2020) marked a strong support level and we are at a mere 10% above that. This makes things interesting.

$8 has been a very strong support for the stock over the last 5 years and if we go further back in time it was hovering at $6 for a long long time. But it is very hard to imagine SGX would trade to that level because that would mean that dividend can be c.6% and PER is at 13-14x which would make it the cheapest exchange (based on the peer list above) by 7-8 turns and provide us the opportunity to buy a high 15-20% sustainable ROIC at c.8% FCF yield. 

So I would draw the downside at $8 and not $6. Conversely, the upside is dictated by the recent $11 but also the valuations of its peers which can be as high as 30x PER, 19x EV/EBITDA and as low as 3% FCF yield. Assuming SGX can generate 50c in EPS in the near future and applying 25x to that, we are talking about the stock going to $12.5. This does not account for the net cash it has on its balance sheet. 

So in terms of risk reward, we have the risk of falling to $8, which is 20% downside from here, but the upside could be $11-12 which is 15-25% upside. Even if we assume the stock falls to $6 which is a scary 47% downside, we have strong compounding as the tailwind which means the stock should double over next 6-7 years. The strategy would be to buy on dips if the stock for some reason collapses to $6, then we will buy more and enjoy much more compounding in the years ahead.

3. Valuations

As with the previous ideas, let’s use the usual three valuation methodologies (FCF, EV and PE) to triangulate to a more concrete intrinsic value. On FCF, we have it at c.SGD500m and using the same 3.5% FCF yield that we used for Vicom given its strong fundamentals, we get to SGD14.3bn and adding back its SGD200m cash, we get to SGD14.5bn of market cap. 

With Enterprise Value or EV, SGX will likely achieve an EBITDA of c.SGD700m in Jun 24. Using 15x which is near the industry average, we get to EV of SGD10.5bn and again adding back cash of SGD200m, we get to market cap of SGD10.7bn. 

Lastly, using Price Earnings Ratio or PER, SGX should be able to achieve Net Income of SGD500m in Jun 24 and using PER 23x which is again the industry average we get to SGD11.5bn and adding back its SGD200m cash, we get to market cap of SGD11.7bn. 

Intrinsic Value 

Taking the average of the three market caps, we arrive at SGD12.3bn and translating this into share price, we get to c.$11.5 in terms of intrinsic value per share (c.20% upside). Co-incidentally, this is very close to the all time high reached during the height of the pandemic in mid 2021. Meanwhile we also get to collect c.3.6% dividends annually. 

To sum up, SGX is an interesting bet on the highly profitable stock exchange business model and the continual success of Singapore to be a bigger financial hub and SGX grows it business moats in the various niche it has created in REITs, commodities, futures and derivatives. This is a good Singapore compounder to own and to keep buying on dips as long as management does not squander away the money. 

Huat Ah! 

Main blog:
http://8percentpa.blogspot.com/

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.