The New Singapore Economy - Part I

One of the Powerhouse Opposition candidate Mr Tan Jee Say wrote a comprehensive paper to revamp Singapore's economy recently. I had the opportunity to read it in full and I must admit it's IMPRESSIVE. You have to give it to him (and the Govt training that he went through). After all that's the quality we would expect from a former high ranking civil servant and PPS (Principal Private Secretary) for the top officials.

Here is my unabashed point form summary that really doesn't do justice to the 45 page report. I urge readers who are free to read it in full. It's available on the onlinecitizen website. Here are the points:

1. Mr Tan Jee Say thinks that Singapore's economy should move away from manufacturing as this industry takes up too much land, labour and resources and Singapore is in short of all three elements. Manufacturing also adds volatility to our business cycle as it relies on global exports which is dependent on fast-changing consumer demand. In today's knowledge based economy, Singapore's reliance on manufacturing does not make sense.

2. Partly due to our big manufacturing industry (and also other reasons), the Singapore Govt had to rely too much on cheap foreign labour to generate GDP growth. This resulted in economic benefits trickling down to foreigners rather than the bottom 20%-30% of the population, causing their income to stagnate or even fall.

3. Singapore's future lies in the service industry but the Govt went into the wrong kind of services by building casinos. The emphasis should be on education, healthcare and creative industries.

4. Cost inflation in Singapore is largely driven by the rise of non-tradable goods and services (55%). While import prices accounted for the rest (45%). This means that costs like labour, fees and perhaps most importantly rental accounted for a significant portion of cost inflation in Singapore.

5. He proposed a $60bn package to address various needs including a restructuring of the manufacturing industry, promoting education, healthcare and creative industries, improving neighbourhoods and quality of life and a reduction in various fees that has added to cost inflation.

The paper also highlighted economic irregularities amongst various issues that really challenges some of our basic assumptions in Singapore. At least to me, it was a totally worthwhile read that was not only informative but also highly educational on economics, policies and moral issues.

Just as an example: he mentioned that the Sg Govt usually resort to price-mechanism to control demand such as in the case of ERP for driving and Foreign Work Levy in the case of importing foreign labour. However there are flaws with price-mechanism bcos the crux of the issue sometimes lies in supply or demand dislocations and using price does not solve the issue but simply add money to Govt coffers.

Take the case of ERP. The real problem has to do with too many cars and not enough roads. In 10 years the car population increased by 20-30% while the length of roads stayed the same. So is it a surprise that raising ERP doesn't work but just add money to the Govt coffers?

In the case of Foreign Work Levy, raising the levy benefits neither the employer nor the employee. Instead it benefits the Govt. So obviously, the Govt would use it in the first instance to restrict employers from recruiting too many foreigners. However this does not solve the fundamental problem: manufacturing and some industries like construction, low-end services are not suitable for Singapore's knowledge based economy. Hence we need to import foreigners to fill the gap.

On moral grounds, the paper also highlighted that is was not just economic no.s that matter, Govt should implement measures that are also morally right.

So, casinos was a major setback. While the Govt tried to promote a different image via the concept of Integrated Resorts, the truth of the matter is casinos come with social costs/issues that are very difficult to avoid.

Minimum wage, besides having a strong economic argument, is also morally right. If we ask for the service and effort of others, we should pay them what is an acceptable minimum amount in our society. When foreigners come, this concept is totally lost and the lower income households bear the full brunt.

Next post, we look at some Govt rebuttals!

Solutions to the HDB conundrum

This is a continuation of the last 2 posts:
Are HDB prices really expensive?
What's wrong with HDB prices?

What is the solution to this huge conundrum of HDB prices being much higher vs its history and vs some Singaporean household income (esp lower income groups) yet lower in terms of rental yield and absolute prices vs other Asian cities?

The Opposition had come up with the cost plus solution. ie if the cost of building a HDB flat is $150,000, then the Govt should just put a tag of say $200,000 and sell it to Singaporeans. While this solution is pleasant to most would-be buyers, it creates huge problems for the system.

First by making new HDB prices widely different from current market prices, you run the risk of enticing speculators to join in the fun. Already, there are young couples who had tried to game the system just to get a good flat at a good location, balloting 10x in the span of a few months. It might become a major issue. Maybe people might just pretend to get married just to get a HDB flat then sell it after 5 yrs, divorce and split the profits. Things can really get out of hand. Hence cost plus model might not be ideal.

It is also imperative to bring prices down slowly over time rather than crashing it, a pointed highlighted by various ministers as it affects the valuation of 1mn homes. If prices crash, a lot of people might not be able to pay their mortgages, go bankrupt and create more problems.

Having said that, there are other possible solutions, which admittedly, the Govt is already implementing. Well, what do you expect, it's our First World Govt after all. They would have thought about it.

Economics will tell us supply and demand determines price. So we should aim for tools that can help us control these, as well as measures that can deter punters. Anyways, here are the some widely discussed must-implement measures:

1. Smoothen supply and leave some slack

If you look at HDB supply of flats over very long periods like 5-10 yrs or more, you see huge ups and downs, some years 20,000 new flats, recently has been 8,000 and lowest was at 5000. They should have learnt long ago not to time such cycles. Knowing that Singapore has 20,000-26,000 marriages every yr, just build say 15,000 flats every year (since not every new couple will get a HDB). Then review the system every 2-3 years.

In fact it might be prudent for HDB to always have some slack. Ensure there are always 5,000 flats available. In times like this, release them and make people happy. After all, if it's the Govt, isn't it ok to have stockpile of flats, when govts around the world stockpile stuff of national interest like oil, rice, or even gold.

2. Increase grants or other benefits to needy

While we cannot go for a cost plus model, we can always increase grants to people who need them. Current grants are like $30-40k when HDB prices can go to $700k. This is a miserable 4-6% of HDB prices. This should be increased to 10-15% to make it relevant.

As for lower income households, HDB can also help by reducing the interest rate for mortgage. Currently it's still 2.6% while commercial banks are giving 0.8%. Perhaps for the needy, HDB can match the commercial rate.

3. Variable LTV

For most speculators, LTV is an important ratio. LTV stands for Loan-To-Valuation and it basically determines how much money a buyer can borrow from the bank to finance the mortgage. For HDB, it's 80-90%, ie one can borrow up to 80-90% of the house price. In other words, punters can simply put up 10-20% in cash and punt the property.

The LTV can be made variable to deter punters and help the poor. Total asset size and household income might be a good place to start. A household with $50k in assets and $50k annual income probably isn't looking to punt HDB. But a retiree with zero income on paper but $50k from overseas stock dividends and $5mn in asset after his condo en-bloc sale might be.

There are other probable solutions to help cool the general property market (not just HDB) and also protect the rights of home owners. Maybe someone should write a 46 page report to address these points.

1. Improve lending rules to deter punters

Albeit this is already being implemented esp on the LTV front. Perhaps more can be done at the int rate level. Implement measures such that commercial banks cannot provide lending at ultra low interest rates as it encourages punting. This might include charging a higher spread over SIBOR or SOR, or maybe even a complete revamp of the system: ie not using SIBOR/SOR but a flat rate of say 2.x%, like HDB. The other solution would be for MAS to raise short term interest rates. However this have far wider economic implications.

2. Tax developers more

Property developers enjoy supernormal profits. If a developer just sell 60% of a condo development and can breakeven, something is not right somewhere. The other fact is somehow any Ah Beng, Ah Seng also can be developers. Look at Popular bookstore, SPH or some of the smaller construction firms. I am not sure about the specifics, but I think there is some loophole somewhere. Increase their taxes.

3. Change en-bloc rules

If 80% of the people say you should let them sleep with your wife, does that make it ok to really let pple sleep with your wife? The en-bloc rule is terrible for someone with no intention to sell their house. Protect their rights - naturally this will disrupt the supernormal profits of developers as well.

4. Land sales

This is coming. Marlboro Tan was pressured to do something to cool the property market. Maybe land supply should also follow the same logic with HDB, ensure some supply in place and use it as a tool to control prices. Also, make it difficult for developers to get land cheaply.

5. Tighten psf criteria

As you should know, they change the ruling some time in the 90s to allow like balcony, aircon area, wall area to count towards floor area of house. Hence old flats are much bigger even with same paper floor area. Change this. Or maybe make sure it doesn't get worse and owners doesn't get shortchanged.

6. Talk down markets

Talk is cheap. Just give some conservative statements. Like "although property prices will rise in the long run given Singapore's progress, the current situation calls for prudence. We urge new buyers to consider their financials when shopping for new homes." Don't just talk Ra-Ra all the time.

7. Restrict foreigners

Make it more difficult for foreigners to buy. After all they are mostly punters anyways if they don't stay here, or have any connections with Singapore. How do they contribute to the well-being of Singapore? Make sure they need to park like a godzillion dollars here before they can buy anything. Oh and their LTV should be like 20% or something. And tax them jialat jialat!

Well these are some measures that can be put in place, albeit some already are. The implications are that property prices will fall, a lot of punters will go bankrupt and the banks with the most mortgages might suffer a little. But it might be a good thing for the future. Take out the froth, endure some pain. At least our kids would be able to afford HDB again and maybe even pursue the 5C dream of owning a Car, a Condo, a Country club membership and have some Comfort in having their own Children some day.

What's Wrong with HDB Prices?

So HDB prices are not overly expensive but everybody blames our Govt for the pitiful state of things. Now new couples cannot afford HDB, not to mention low and middle income families, old folks, the disadvantaged. If they cannot afford HDB, where are they going to live? How are they going to survive? The sentiment on the ground is definitely very different from what we have established in the last post.

We shall look at a few issues that might shed some light into the disconnect:

1. Then and Now
2. Sour Raisins
3. Policy Blunders
4. Broken Dreams

Then and Now. Most people have great memory with regard to two things: their salaries over the years and their home prices. This point illustrates how the Price to Income has changed for HDB over the years. Long long time ago (like the 1970s), as the older generation would tell us, HDB flats were going for $20,000. Back then the pay was like $600 per month, so price to income was a mouth-watering 2.8x! And nobody wanted them! Okay maybe that's too ancient and not so relevant. Let's look at 2007. According to HDB website and Singstat, 4-Rm HDB was going for $241,000 and our median household income was $59,000 or so. That's still a cheap 4.1x compared to 6.4x today.

So while HDB is still cheap today when compared to other Asian cities, it is definitely much more expensive compared to its own past. Our incomes have not risen as fast as home prices. Everybody knows that. Well... except the Govt. Or actually they did know, maybe they just had a different agenda: like building the country's reserves or something.

Sour Raisins. To make things worse, our low income households bore the full brunt of higher prices. In 2000, the monthly salary of the lowest 10% was $1,276. In 2007, it went up to *drumrolls* $1,221. Sorry, it actually went down by $55. Finally in 2010, it went up to *drumrolls and crackers* $1,400. An increase of a whopping $12 per year from 2000 to 2010! How impressive! Meanwhile the top 10% grew from $14,959 to $23,684. Close to $10,000 increase. Answer to the recent poll: 17x difference.

Okay, that's a bit dramatic. But the point here is that the lower to middle income group hadn't had it easy. While the top 20-30% of the population enjoyed higher salaries, get to eat at fancy restaurants, drive new cars, upgrade to better 5-Room or Executive HDBs or even condos (yes this refers to all of you money-grubbers reading this blog!), these low income families are eating from hand-to-mouth. It's not even sour grapes, it's leftover sour raisins. And they have to share with their kids while servicing their 35 yr mortgage.

Frankly speaking, it doesn't really matter to them whether the price to income is 5x or 10x, to them it's always 35x, or until retirement. They definitely don't benefit if prices go up, bcos it's their only home and they cannot sell. The Govt seriously needs to do something here. Albeit they are already lending a helping hand, just that it's not publicized that much.

Policy Blunders. While HDB prices are inexpensive, I guess what really gets on peoples' nerves are various policy blunders that led to lower quality and service, like diminishing floor area, supply demand issues and the stupid 8k rule.

On lower quality, it's no secret that home sizes are forever shrinking. An old 4-Room HDB are now as big as 5-Room. Maybe in another 10 yrs, a 5-Room would look like Mickey Mouse's toilet. Bcos they counted the floor area of your balcony which is now bigger than your living room, the aircon unit, the common corridor and staircase as well! Why is this allowed to happen? Talk about major policy blunders!

Quality of finishing also had some hiccups. Remember the aluminium window frames that fell off? Or wall tiles that keep cracking? Well, admittedly, some of these issues have been resolved.

On lower service, this is actually tied to the supply demand mismatch. Basically new HDB owners have to wait on average 2-3 years or so before they get their flat thanks to HDB's "policy" of building behind curve and always in a roller coaster fashion. Just as an example, they overbuilt in the earlier part of the decade, flooded the market with tens of thousands of flats in Boon Lay and Sengkang. Then decided not to build anything, which led to the current situation of newly weds having to wait 2-3 yrs between ROM and customary ceremony. Meanwhile we want higher birthrates!

And now HDB decided to go all out and build 40,000 flats in the next 2 years, staging the market for the next cycle of boom and bust.

So despite paying up for a more expensive home, Singaporeans have to wait longer to live in a smaller unit with probably more defects and subjected to illogical rulings like an 8k income limit for a $780,000 flat.

I guess that is the ultimate unforgivable deed.

Broken Dreams. So far, all the analyses are being done on HDB. Prices though not as expensive as other Asian cities, are rising too fast too furious and policies are crap. Hence there's a lot of dissent on the ground. The far more important piece of the puzzle, is actually the private condo market. Even without doing any detailed analysis, most rational people would come to the conclusion that the Sg property market is frothy. Just a quick glance of two measures: Price to Income is more than 20x if you use median household income, or 13x if you use the 90th percentile. Rental yield is closing in on 2%. ie Froth-on-your-Tiger-Beer level. Any frothier, it's either going down the throat or the chute.

But the biggest setback posed by the private home market is this: It destroyed the 5C dream. THE Singapore dream. An average condo now costs more than a million bucks. Actually the average price is probably like S$1,875,000 (using $1500 psf times 1250 sqf). This means that 80% of the population with annual income of less than S$100k, cannot afford to upgrade to a condo, no matter how hard they try. Bcos it will take them close to 20 yrs just to earn that face value, assuming they spend nothing. With the new ruling of only 60% LTV, it means you need at least S$750k in cash or CPF to buy an average condo. Well, if you have S$750k, I guess it's better to buy yourself 20 yrs worth of food and staples in preparation for retirement. Bcos those are the next items to skyrocket in prices.

So that's the long and short of it. Singaporeans are probably more unhappy with uneven distribution of fruits of labour, policy blunders that let to poorer quality and service and the broken 5C dream. More so than just rising HDB prices itself.

Next post, we discuss some possible solutions!

Are HDB flats really too expensive?

With the election fever running high, it is probably apt to re-visit the property topic, a boiling hot button issue that is on everybody's mind. While various statistics had been throw around by the media, nobody actually believes them. So here is an independent analysis of whether HDB flats are really too expensive.

We shall look at a few measures:

1. Price to Income
2. Rental Yield
3. Absolute Prices
4. Housing Debt to Income

Price to Income is one of the most widely used affordability measure. Basically it is just median housing price divided median income. (info from HDB and Singstat). For Singapore, I am using the the 4 room HDB median price of $385,000 dividing the median household income of $60,000 which gives 6.4x. If we use 3 room, the ratio becomes 5x. Globally, this ratio ranges from 3-20x. Anything close to high teens is usually considered bubblish while anything below 5x would be consider cheap. In developed Asia, most cities are at a high single digit or low double digits.

Tokyo 9x
Guangzhou 8x
HK 11x
Shanghai 10x
Beijing 12x
Taipei 11x

Hence strictly speaking, HDB prices are not that expensive, but we cannot really say it's cheap though bcos 3-5x price to income is relatively common in other parts of the world, esp in sub-urban areas.

However, if we add in condo prices, Singapore is then close to 20x ie higher than most Asian cities, read: bubblish levels.

Rental yield of HDB is calculated using info on HDB's website. Basically using annual rental divided by the median price.

Rental
http://www.hdb.gov.sg/fi10/fi10323p.nsf/w/RentOpenMktStatisticRent?OpenDocument

Median prices
http://www.hdb.gov.sg/fi10/fi10321p.nsf/w/BuyResaleFlatMedianResalePrices?OpenDocument

The rental yield comes up to around 5-6% for 4-Rm, 5-Rm and Exec and *pause for effect* an amazing 7% for 3-Rm HDB. Again global rental yield ranges from 1-9% with 1% yield during bubbles and 7-9% during crisis. The average yield being closer to 3-4%. So again, HDB rental yield at 5-6% are not exactly indicating that they are overly expensive.

However we must also understand that the HDB rental market has its own idiosyncratic issues and also the no.s quoted are gross yield. With the Singapore RE market, there are various charges that come in such as agent fees, ridiculous renovation fees, down periods and fickle tenants. Esp with HDB, you can expect more problems and hence fees/downtime to take a bigger chunk out of gross yield bcos the absolute rent is not high to begin with. We are talking about S$1300-2000 per month. Tenants also tend to be very price-sensitive and picky, bcos if they aren't, they would have chosen condos. So a 5% yield might be just 4% in reality.

In terms of absolute prices per psf, well I guess most avid Singapore property followers would be more updated than me. HDB psf prices are roughly S$500-800, as compared to Sg condos which can be S$1000-3000. In comparison with global cities, the average is probably S$1200-1500. So again, HDB prices are not that expensive. However if we compare sub-urban areas, then prices are way below our HDB prices.

As for housing debt to income, HDB minister Marlboro Tan quoted that we are about 30%, which is not different from global standards. Granted, most Asian cities are higher, at 35-40%. But again, in US, 28% is what credit agencies would recommend, so we are just a bit higher than that.

Just to summarize, let's look at how HDB flats fare on these four measures

1. Price to income: fair to slightly expensive
2. Rental yield: Cheap in gross terms, maybe fair in reality
3. Absolute prices: Fair in total, cheap compared to cities
4. Housing debt to income: Fair

So on four counts, HDB is probably expensive on only 1 count: Price to income. This is however the most important measure out of those four as it directly determines how the buyers' incomes relate to home prices. Then again, bcos HDB is actually fair or cheap on various other measures, it makes sense as investors to buy HDB flats.

So we established that HDB flats are not way over-the-top expensive, esp so when compared to other Asian cities. In fact it gives a decent yield if we gauge them as investments.

Why then are Singaporeans so angry with our beloved Govt?

Next post, we shall examine the red-hot button holes and threads in detail!

See also Solutions to the HDB Conumdrum.

Hyflux Preference Shares

Like most yield hungry Sg investors, I have been googling around on Hyflux's preference shares, but sadly, the information online is still somewhat lacking. One of the best analysis out there is done by la papillion:

http://bullythebear.blogspot.com/2011/04/hyflux-preference-shares-part-1.html

The blogger has written a blockbuster trilogy as well, do read through his whole analysis, totally worthwhile! Considering that the deadline for subscription is like 3 days from now, I guess this will be the first and last post for me.

For those really dunno what's going on, Hyflux is the leading water company in water deprived Singapore. The mkt cap of the firm exceeds a billion dollars, which means it is not your small fry SGX listed co, this can be the next Keppel Corp one! Recently, the firm announced this plan to raise S$200mn via pref shares with perpetual yield of 6%, with a step up to 8% some years out.

A pref share is similar to a bond in the sense that it gives you an interest income (well in this case a more or less compulsory dividend). The difference being that the dividend is perpetual (at least theoretically). Also pref shareholders are junior vs debt/bonds but senior vs common equity. This means that if the firm goes bust, pref shareholders stand to get something only if all bondholders have taken their share - ie nothing much left lah. However, pref shareholders usually enjoy a higher dividend. In this case, a good 6%!

As for Hyflux, there are various issues involved and I will simply summarize the pros and cons briefly here:

Here's the good part first.

1. The dividends are cumulative - ie if they fail to pay one time, they must make up next round, ie you will more or less get your 6% over time.

2. The dividend must be paid as long as common shareholders are paid, bcos pref shareholders are ranked higher vs common shareholders. Looking at its common dividend, Hyflux's track record is ok, not super stellar but at least got dividend every year since a couple of years ago, albeit the yield is pathetic, like 2% kind.

3. Hyflux enjoys the support of the SG govt, while it is unlikely that the govt will step in to save the stakeholders (ie debt or shareholders) in the event Hyflux goes belly up, it is also unthinkable that Hyflux would actually go bankrupt in the next 3-5 yrs. The govt has in the past been supportive of Hyflux, awarding landmark mega contracts (like the first de-salination plant etc) to the firm every couple of years.

4. It is a well-runned company. Top management knows their stuff and has earned the respect of both investors and competitors. Just that it is in a bad business. More on this below.

Here are the cons:

1. Why is the firm doing such a detrimental financing? They can always borrow from the banks at a lower rate, but they chose pref shares, and have to pay 6%. It might have something to do with their credit rating, if they raise more debt, the rating will fall. It then also says something about their financing options. Last checked, the firm has S$1bn in debt and S$500mn in equity. It's definitely higher than most SG blue chips although not that bad if you compare it with global co.s. Maybe the uprising in Africa is really taking a toll on their businesses. Or maybe Olivia Lum thinks that she should share her success with all Singaporeans. Well that is my wishful thinking :)

2. Hyflux's business model is not robust. It relies on winning projects, which in turn is economic sensitive. Even worse, its growth relies on winning ever bigger projects, most recent ones were like US$1bn or more one. In bad times, like during Lehman, project pipeline dries up and cashflow goes into red.

Also, they have no say over the price, they bid for the projects and can only win with lower bids vs others. Inflation in the last few years is causing their input costs to go up. Now with Libya, I suspect they are not in a good shape although a recent SG project should help. This validates the point made above: the SG govt lends a hand during bad times.

3. The cashflow track record is not exactly great. Over the last few years, they averaged FCF of S$30mn, which means that this pref share dividend alone will eat up S$12mn or 40%. There is one year the FCF went into -40mn, so if that happens again, the shares WILL plummet, both pref and common, like it or not. In short, not too much of a buffer that can guarantee payment until perpetuity.

4. The shares will trade on SGX come end Apr, which means that there might be downside risk if you need the money. It can be trading at $80, then you lose 20%. Of course I suspect it should trade above $100 in the next few weeks bcos Sg investors are suckers for such high yield. Already it's oversubscribed by 8x or so. But we must remember when the going gets vicious, it is likely this thing can go to $70 or even $60. The OCBC pref shares went to $80 during Lehman (now $104). If that happens, you have to ask if you are willing to add more :)

4. Hyflux is likely to buy back the shares asap, 6% of 200mn to pay every yr is no joke (S$12mn as mentioned, or roughly 40% of its FCF), but that's ok even if we just get a couple of yrs of 6% as the shareholders.

5. Finally if you subscribe, you need to do some guesswork, bcos you are not going to get everything. From the 8x oversubscribed no. probably $100k will get like $15k or something. Then again, you must be prepared you might get everything, but this is quite a low probability event now.

Conclusion: Probably an ok deal though not entirely secure like buying the safe and sound blue blue chips. Buyers would be betting on some implicit government support in really, really dire straits, a competent management that knows what they are doing and of course the 6% yield. 2 days left to go to the ATM to subscribe!

The Nuclear Saga Continues

After 3 weeks of intense battling with the nuclear reactors, our heros at Fukushima aren't really winning. In fact the situation is going from bad to worse. Radioactive substance is found in almost 100 different types of food, seawater is contaminated, tap water in Tokyo cannot be drunk, the area around Fukushima would probably be unlivable for the next 20 to 30 years.

The final outcome might be similar to Chernobyl, ie pouring a few hundred thousand tonnes of concrete to entomb the reactors. Even that is just a temporary fix. Ukraine now needs financing for a permanent structure to seal Chernobyl and has difficulty getting it.

The key company in question, Tokyo Electric Power or Tepco, meanwhile fell 80% over the last 3 weeks and it looks like it's going to zero. The reasons: cleanup, decommission, compensation costs is likely to wipe out its entire equity. Even bondholders might need to bear the brunt.

Tepco is also a sad case of becoming a political sacrificial lamb. Its public track record has been dismal. The co was run by ex-bureaucrats "descending from heaven", who are there to enjoy retirement rather than to run a company. Experts warned the company about inadequate measures, both Fukushima and also another nuclear plant that was affected in the past, but were brushed aside. And of course, the most unforgivable mistake: mis-reporting the radiation levels! Man, wake up your idea!

So while the earthquake, theoretically speaking, was a natural disaster and hence Tepco should not be asked to pay for compensation to the farmers and the fishermen, the Japanese govt would likely let it shoulder the bulk of the cost. Not to mention, the govt itself is really tight on budget. It cut the child allowance to raise money for the handling this disaster. Sorry kids, no milk for you until you are 18, and we have to send you to study in University of Heidelberg, where education is free.

But even without the compensation costs, the other big ticket stuff like decommission of the plants, replacement fuel cost and other nitty gritty are likely to put a huge dent into the equity. Assuming the market is correct, these should add up to like USD 20 plus billion, roughly equivalent to the fall in value of its market cap.

For the retail shareholders who held this stock for its dividend, tough luck. Suddenly, almost the entire capital is gone! I guess this truly highlights the risk of equity investing, or rather, any kind of investing. Things can go really, REALLY wrong! Hence it's always prudent to just put money you can afford to lose.

The bigger lesson: diversify. Make some kind of rule, like never put more than x% of your net worth into one investment or something. While it will be difficult to hit the jackpot, at least, if something like Tepco happens, the kids still can have their milk or go to a school of their choice.

With the nuclear story going down the chute, the smart money is pouring into LNG, oil and coal. This is the sad outcome: the world will become a hotter place. Well if we get to tap on more of LNG, it's not so bad bcos it's still the less carbon intensive among the three.

But LNG requires huge infrastructure: the gas pipes, the LNG tankers, the terminals to store them, liquification and gasification equipment etc. It would take some time for Asia and some of the emerging countries to build this up. Meanwhile the LNG stocks have gone to the moon in recent days. Check out Woodside Petroleum of Australia.

I guess in time to come, the world would realize that it still needs nuclear energy. Nothing is as cheap, reliable and scalable in a big way. Hopefully we won't have to wait 25 years after Fukushima. Or we would be wearing a lot more dry-tech T-shirts and using a lot more Ice-Type face wipes!

A Long Nuclear Winter for Nuclear Stocks

The nuclear industry was one of the sexiest story for 2010. With the BRIC's rising fast, the world's hunger for energy looks insatiable. Renewable energy, bio-fuel, oil sands, nuclear were the buzz words. Nuclear was special though. It's clean, cheap and scalable in a big way. It can contribute 25% to the global grid if the world's govt put in the effort. Some developed countries are at that ratio. France, the No.1 nuclear supporter, is at 70%. Sadly for the world, today it's still a miserable 14%.

Undoubtedly it will go down below 10% in the next 10 to 20 yrs, thanks to what had transpired at Fukushima. Almost every country with major nuclear plans started talking about holding back, including the US, France, UK and India. Germany, a country that had never believed in nuclear after Chernobyl went a step further to expedite the decommission of existing plants that are deemed too old. Finally, a couple of days ago, China the last man standing, decided to review its nuclear power plans.

As for nuclear stocks, which were darlings just a couple of months ago, became dogs. On average, they were down 30%. Some of those most badly affected by Fukushima were down 40-50%. Some are now trading at 10x PE multiple, as compared to at least 15-20x when the story was hot.

I guess the lesson learnt here is one on valuation vs story: never pay for a sexy story. Just like Buffett, he is known never to pay for growth. Value investors should follow Jerry Maguire. Show me the money first. Buffett pays a good multiple for a good franchise, with strong track record but not for concept, nor sexy growth. Well he did buy BYD, but he paid HK$8 for HK$0.60-0.80 earnings ie 10-13x at that time. That's not so bad. You have to give it to him lah.

If you have a hunch for a good story e.g. nuclear or smart grid or cure for cancer, look for beneficiaries but also look at the multiple. If it's 10x, well that's a no brainer, buy. If it's 15x, then you need to ask, okay, is the growth going to be more than 15% and how sustainable is that, 2 yrs or 5 yrs or 10 yrs? If it's 20x, then forget it, even if it makes the growth, you have paid $1 for $1 worth of goods, there is no additional upside.

The nuclear stocks were just that. trading at high teens, the growth was factored in and when Fukushima came about, they cracked, like a Singaporean having a hard time in Mumbai, after drinking its water.

So now is it time to buy nuclear stocks? Sadly, I don't know. Some of them are now 10x, yes that is cheap, but earnings might decline going forward. After Chernobyl, we know the industry is not going come back for a long time. Last count, it's about 25 years. It's a long nuclear winter ahead. Maybe this time we are in a different era, we are really short of energy. Maybe the governments will finally get rational as they know that without nuclear, we are going to make the Arabs very rich and Qaddafi very powerful and that is not good. So they push ahead with their plans for more nuclear power. Well, that is wishful thinking perhaps.

As a last note, it is worth highlighting that for all the unfortunate souls who suffered or died from the effects of nuclear radiation since nuclear came about, the worst impact was not the pain nor the fear of dying. It was actually discrimination, by "normal" people. Imagine telling someone you just met that you are from Chernobyl in 1986 or Hiroshima in 1945. Next thing you know, they are ten feet away and running. Shunned by society, these victims suffered the most at the heart, not the body.

I hate reducing people to numbers, but it tells the story really well. So this is the punchline: The number of victims due to nuclear accidents since the birth of nuclear energy is less than 10,000 in all. In comparison, 20,000 coal miners dying every year. Not to mention the many millions more who get affected by polluted air and water. So should we be shutting down coal mines or nuclear plants?

For a solution that can solve a huge part of Earth's energy problem, Chernobyl and now Fukushima does really have a disproportionately huge negative impact far beyond what the media monkeys can imagine.

Anyhows, for now, let's just hope that our 50 heros at Fukushima can save the world this weekend!

Blue Ocean Strategy

This is the name of a popular book published about 5 years ago that helped improve how the top management of many companies think and how they should come out with strategies to help their company grow.

I started reading this year (yeah, I know...) and found some intriguing ideas that I thought I should share it here. Here are some of those that would really help investors when they do some analysis on companies.

1. Blue Ocean Strategy simply refers to innovations that companies come out with that separate them from the competition. The strategies centre on creating uncontested market space, new demands which was non-existent in the current world (red ocean). This can be done by reconstructing market boundaries by focusing on value-add to end users, combining virtues of different but competing industries or simply creating a new product. The strategy also involve reducing current cost structure while creating new demand thereby helping grow both the topline and the bottom line at the same time.

Some well-known examples of Blue Ocean Strategies would be:

Apple's iPhone (redefining value-add to users)
Apple's iPad (new product, new market)
Nintendo's Wii (expansion of gaming to non-core gamers)
Cirque du Soleil (combining virtue of circus and art)
NetJets (value add of both private jet and commercial airline)
Berries (focusing on fun-to-learn Chinese for English-speaking kids)

2. According to the book, blue ocean strategies are usually not created by new players in the market, nor by technology, nor by big companies. Most companies never continuously come up with blue ocean strategies. The unit of analysis, then, is not a company, nor industry, nor change in technology. The most appropriate unit of analysis is therefore the strategies.

3. Blue Ocean ultimately becomes Red Ocean as competitors catch up. Fat profit margins eventually go down and the whole industry succumb to volume and price competition. ie pursuing profit increase by growing the revenue (usually targeting only single digit improvement) and/or reducing price (by reducing cost and passing on this benefit to clients).

For investors, we should always try to look for companies that are going into wonderful Blue Oceans which they are creating. Companies with strategies venturing in the Blue Ocean ultimately enjoy huge profit growth that are not factored in by the markets. However it may not be easy identifying such companies, hence it is still important to look at the valuation of the stock while betting on Blue Ocean.

This means that as value investors, we cannot buy a Blue Ocean company when the PE is 20x. It goes against the grain of value investing. What if the Blue Ocean turns out to be only a 1 yr phenomenon, then we are pretty screwed bcos when we bought at 20x, and the market is usually discounting a few good years ahead. A good investment strategy would probably be buying into a cheap stock with potential to unlock a Blue Ocean.

However we must also be cognizant that Blue Oceans will ultimately become Red Oceans. Blue Ocean stocks probably see their intrinsic value explodes in the first few years but later plateau out or even decline. This is in contrast with the fantastic Dividend Aristocrats whereby the intrinsic value simply rises over time usually for decades.

Colgate-Palmolive - Part 4

Finally, we have here a quick cheatsheet of Colgate's financials.

Basically, it's a company earning USD 4bn on a revenue base of USD 16bn every year and we can expect this to grow maybe 13-15% for the next few years. This growth factors in all we have talked about, including P&G's entrance, GDP growth etc.

Toothpaste is a business that doesn't need a lot of capex, so basically free cash flow is used to pay shareholders. It's free cash flow is about USD 2.4bn, and the FCF yield is 6%.

The interesting part about Colgate's financials would be its balance sheet. Some would argue that it's not exactly great. Debt at USD 3.4bn is greater than its equity of USD 2.8bn. So isn't this risky?

My take is that the management has basically optimized the balance sheet to the hilt. Why is the equity so low? If you notice, equity at USD 2.8bn is the same as a single year's net profit.

This implies that the co. has been paying back equity to its investors. Bcos the business doesn't need money to grow. Whatever excess money made is paid back to shareholders. Although dividend is 3%, Free cashflow yield is actually 6%, I am guessing that the other 3% is used to buy back shares.

And the debt of USD 3.4bn can be easily paid back in less than 2 yrs, using its free cashflow.

However, having analyzed all these, I must admit Colgate is not cheap. PE is 13x two years out, while growth is also roughly 13%. Looking at other measures, EV/EBITDA is a good 10x. This stock is simply trading at its intrinsic value.

The bet here is that the intrinsic value will grow over time. From its track record, it doubles every 8 years or so. Given its current outlook, with growth from emerging markets and some margin improvement, it might take a little shorter than that.

So buy Colgate-Palmolive, get that 3% dividend and see it double to 6% in 6 years and double again to 12% in 12 years! That's a Dividend Aristocrat for you.

Colgate-Palmolive - Part 3

Every stock has its risks and here we talk about Colgate's.

Colgate's biggest risk comes from its competitor - P&G. This company is the nemesis of Colgate, like Jedi vs Sith, Windows vs Mac, Man U vs Liverpool. You get the idea!

P&G has 24% of the oral care market, just a tad smaller than Colgate's 26%. P&G owns Crest - the other big toothpaste brand in US and some other parts of the world (but not in Singapore) and Oral B, the toothbrush specialist.

As we can deduce from our own personal experiences with these brands, P&G probably has a bigger market share in the not-so-profitable toothbrush and other oral products (like floss, denture solution, rinse etc) and a smaller share in toothpaste, where Colgate is really the gorilla here.

Now P&G has been trying to break Colgate's dominance in toothpaste, hence they are been aggressively pricing their products in various important markets. They are really pushing toothpastes of Crest and Oral B into the emerging markets and the biggest market - the US.

This perhaps explained the weakness in Colgate's earnings and stock performance over the past 12 to 18 mths. P&G had some moderate success and Colgate's sales growth in emerging markets indeed slowed in the recent quarters.

With risks in investment thesis, it is also usual practice to come out with mitigating factors, which would help dilute the risks. So for P&G, I guess the mitigating factor would be that the situation would probably be temporary.

This is bcos once P&G reach a optimal market share where it enjoys economies of scale as well as optimal profitability, it doesn't make sense to cut prices to gain volume any further bcos the marginal profit goes down significantly.

Let's rationally thinking about this. In a market where 80% of people uses Colgate (like Brazil or Singapore), there are probably some people who would switch to P&G bcos of price. So we can expect Colgate's share to fall. But after it falls to 60%, ie P&G now has 40% of the market, does it make further sense to throw a ton of money into advertising, sales rebate to get shelve space, and to further price cuts to gain the additional 10%?

Toothpaste is a very personal choice, there would be a group who would never switch from Colgate bcos they like the taste, or the colour or whatever. So it gets harder and harder to get more share.

Of course, P&G also risks Colgate's retaliation. Colgate has lower manufacturing costs bcos of its bigger scale and its first mover advantage. Colgate's local factories are probably built years ago, fully depreciated with more experience staff and sales people. If Colgate embarks on a price war, P&G will lose.

Hence it is likely that P&G would stop cutting prices once it has gained some share and some loyal customers. P&G stands to gain more by maintaining prices, improving margins and just enjoying the organic growth of the market. As the market is growing rapidly, I believe there is room to accomodate 2 players. This means that Colgate would not get to same spectacular growth it enjoyed bcos of P&G's entrance but it's still respectable growth in a great business in the right geographical regions.

As a last note, in a industry where there are only a few players, it make sense to maintain some price discipline such that all the players can make good margins. This is something akin to the Prisoners' Dilemma that we talked about. Both players stand to gain if they cooperate rather than fight.