Tobin's Q: The q ratio

It has been a long while since we discussed financial ratios. The last post was more than 10 years ago (although it was edited in 2016). Today we hope to discuss Tobin's Q and how it can help us in our fundamental analysis. First let's define what the heck is this ratio about.

From Wikipedia:

Tobin's q (also known as q ratio and Kaldor's v) is the ratio between a physical asset's market value and its replacement value. It was first introduced by Nicholas Kaldor in 1966 in his article "Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani".

It was popularized by James Tobin, a Nobel laureate who did creative and extensive work expenditure decisions, employment, production and prices in finance. He famously stated:

1) the numerator, is the market valuation: the going price in the market for exchanging existing assets.

2) the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.

There are various formula for Tobin's Q and one of which is the basic price-to-book ratio. But the version that I think makes the most sense is the following:

Courtesy of Investopedia

There is a full explanation on investopedia so I will not go into the details here. As with price-to-book, the concept is that a company's market value (i.e. stock price or market cap) should approximate its replacement cost and therefore the ratio should always be close to one. Alas, as stock prices go, it is everything but. 

Today, price-to-book ratios usually go into teens for good companies (which is the usual level for price-to-earnings in the past) and in most analysis, it is no longer a useful measure. What is more important could be free cashflow, price-to-earnings (the starting point is usually teens and we try to determine whether 30x is too expensive) and growth rate.

Tobin Q can also be used for the entire stock market. Since 1945, the Federal Reserve publishes a quarterly Z.1 Statistical Release which provides the raw data for the q ratio's calculation. There is also data using different sources before that. For more details, please refer to the following salient update from Advisor Perspectives: 

https://www.advisorperspectives.com/dshort/updates/2021/12/02/the-q-ratio-and-market-valuation-november-update

What is important with such ratios usually is to compare the numbers across its history. The following chart shows that the Tobin's Q ratio is at its highest level ever. This is even higher than the level reached during the dotcom bubble for the entire US market. There is argument that the raw data understates the denominator, as such, the ratio rarely dipped below 1x over the last 20 years, but still, we cannot say the market is cheap or fairly price. We are quite far from that.

Courtesy of Advisor Perspectives

A lot of luminaries are saying we are in the mother of all bubbles, this ratio is another datapoint confirming the danger. It pays to be prudent now. Be fearful when others are greedy, but this time, cash may not be the safest hiding place, so we may need to diversify. It might be worthwhile to look for companies trading below 1x their Tobin's Q ratio and many other asset classes including gold, crypto or hard assets. 

Thoughts #27: Scams and Counterparty Risks

Human civilization has progressed so far that we sometimes give a lot of the benefit of the doubt to be trusting. We buy bottled water, packaged food trusting it is all good. We buy things off the internet like nobody's business today, trusting that our purchased goods will arrive at our doorsteps tomorrow or at worst, in a few days. 

It was not always like this. We have become too trusting and there are scammers out there who are getting really good at scamming in this unique era of ours. Scammers existed throughout history and we simply must always be vigilant. Our parents and older friends and relatives are also usually more vulnerable.

This post is a reminder that sometimes the most important risk is simply the other party or platform across the table. It could also be people we are supposedly working together with. If we have a counterparty who is helping to transact, can we trust him or her? Are we using a reputable broker? Is the Bitcoin exchange setup certified by the MAS? Can we trust the property agent, or the supposed seller/owner of the property? These are simple things that we should make sure that we do not overlook. 

Scams are also everywhere. Some are easy to spot but others may not be so. Bernie Madoff structured his Ponzi Scheme for almost 40 years and no one found out because he was so good at covering his tracks. Jho Low pulled off the 1MDB by registering similar sounding company names. Internet scams are everywhere, so it's better to just buy from the big platforms rather than to try to save 20%.

Needless to say, when we are buying big ticket items, like a luxury watch, a car, or a house, then it makes even more sense to be beware of scams and counterparty risks. We need to double and triple check that everything is in order. A good friend shared this with me some time back:

"When you are about the part with your money, think again and double check. Pay half or 1/3 first if necessary. Things will change when money has been transferred"

Caveat Emptor!

Books #17: Value Investors by Ronald Chan

I read an interesting book in 2021 simply called, "The Value Investors" by Ronald Chan. Well the full title is apparently - The Value Investors: Lessons from the World's Top Fund Managers. 

This book is unique as it introduced the many value investors that we may know but had never been featured prominently. People like Irving Kahn, Walter Schloss and a few Asian value investors including Singapore's own Teng Ngiek Leng, founder of Target Asset Management. 

There were many snippets and many lessons. I find the Asian lessons particularly useful as I could relate better.

Teng shared the importance to be flexible and be contrarian. This was echoed by Howard Marks who famously coined Second Level Thinking, which needs to be different but better. But Teng was able to connect that with his Asian experience, which brings the point home in a unique perspective for me. Another Asian value shared about the importance of knowledge and focus. We can only capture opportunities with knowledge which we have gained with a lot of experience and focus which is required because the opportunity will pass quickly in the markets. Otherwise, opportunities are simply easily missed.

One of the best quotes was from another Asian investor:

I believe that every human being has an artistic gene and in his or her lifetime can create at least one masterpiece that is globally competitive. However, to become a professional, you need to replicate your talent again and again if you are to have more than one masterpiece. It is the same as investing. You can be passionate about it but if you want to become a professional investor, you need to develop a system and have the talent to find good investments repeatedly.

Overall, a great read, do pick it up in 2022!

Ukrainian War and Peace

A few hours ago, Russia decided to do the unthinkable which is to invade Ukraine when the world is still nursing itself from the disruption caused by the pandemic. It was reported that Russian forces poured into Ukraine from multiple locations and lives had already been lost on the battlefields. Global markets collapsed with major European markets falling 5-6% as we speak. Russia's own stock market fell 30%!

Oil prices which went negative $40 last year at the height of the pandemic is now at a multi year high of $105. This is the crazy world that we now live in. Imagine if we had bought oil at -$40 last year and now we can sell at +$100! How does the return calculation even work?

Meanwhile, individual stocks are badly hit. In Singapore, index names like banks fell as global investors take risks off their portfolios. Air travel related names got their second punch in the face (the first being the pandemic) and fell a good 4-5%. Food Empire, with its core business in Russia fell close to 6%. Only oil related names did well given the rally in crude.

It is unclear what is Putin's play here. Does he want to leave a legacy, be remembered as the Russian leader who united Ukraine and the ex-USSR nations? Or he simply wants to use this opportunity to stir shit, play geo-politics and stay in office for as long as possible? Or is it really pre-emptive because if Ukraine joins NATO, then Russia will see dark days with NATO at its doorstep and surely he doesn't want to be judge by history as doing nothing when that happened. 

However, it is said that this war will cause at least 50,000 lives. Already, hundreds of soldiers and a few civilians have died. So what is the math here? 50,000 lives and thousands of Ukrainians and Russians suffering and all the sanctions that will come with the invasion (which will cause even more suffering for the rest of Russia) is worth Ukraine not joining NATO and Putin's legacy not getting tarnished?

Well, let's leave the moral questions aside for now. What can investors do about the current situation?

As with most crises, this would turn out to be a buying opportunity if we have the stomach for the volatility ahead. We have gone too far down the QE addiction that any decline will be supported by governments to devalue fiat currencies, thereby inflating the values of stocks, investments and other assets. However, if war breaks out in the same magnitude of WWI, then we are in a different regime. We shall revisit this doomsday scenario later.

STI's stock reaction today

It is worth noting that quality stocks are not falling as much as the high beta names. For example, amongst the European stocks that I track, weak names like Bayer and Rolls Royce are collapsing while stronger names like Diageo and Adidas are holding up much better. In Singapore, similarly stronger names like Singtel and SGX did not fall as much as Venture and the Jardine names (see table above). It also seemed that we are not seeing real capitulation yet, so the bottom may come only next week or the week after. 

This is a good reminder that we should always stick with strength and quality. These stocks are boring but precisely in times like this that we don't lose sleep agonizing over why they are falling like rocks. Although I must emphasize that the heydays of Singtel could be over. It is on its way to become a dumbpipe. Also, I did recommend Jardine Cycle and Carriage as a holding but it's not in the same league as SGX and Diageo, for sure. So, sometimes we just have to stomach the volatility that comes with some of these higher beta plays.

Of course, if this escalates to full blown war, then no amount of buying on dips can help. I have held the view that we always face a remote possibility that all that we know about modern finance and money can be gone one day. During the GFC, we came close to that. I am talking about the breakdown of the global financial system, all our savings in the banks gone and fiat currencies no longer hold any meaning. If this war escalates to something like WWI, then that nightmare scenario comes back.

When fiat money loses meaning like Venezula's Bolivar 

- being folded into swans to be sold in USD

Therefore, I have always advocated that we should hold some tangible assets like gold, luxury watches, jewellery and things that are outside today's financial system that can retain value. Hence I also have changing thoughts on Bitcoin which I hope to blog about as well. However, Bitcoin bought at crypto exchanges are still part of the system so you do need to get the Bitcoin into a cold wallet and keep it safe. The other important asset is real estate. But you need to have at least two. One to stay in and the other to sell when savings run out in a protracted war.

Let's hope we don't get there and let's pray for the people in Ukraine now. I am sure Putin is not thinking of escalating the situation to a world war and let's hope the world can find some resolution and avert this nightmare and we can look back in a year's time and feel smart that we bought into the market courageously next week, or even this week.

Huat Ah!

Revisiting SIA Engineering

SIA Engineering (SIAEC), together with its parentco, has been badly hit by the pandemic. Its share price collapsed from S$3-4 levels to S$2-2.5 today. Years ago, I wrote an analysis with a bear case scenario that determined that the intrinsic value should be S$3.5 given that it will still earn S$200m of free cashflow (FCF) annually in a "downturn". My bull case has an intrinsic value of S$5 supported by annual free cashflow of S$250-350m!

SIA Engineer's five year share price

Well, the pandemic threw everything out of the window. SIAEC went into losses last year although it did continue to generate FCF, amazingly. This was S$150m in FY2020 (not to far off from my S$200m!) and S$80m for the first half of FY2021. So if we can get pandemic out of the way in 2022, then this can really be an interesting pandemic recovery play! But this is not post to gloat about the accuracy of my numbers. I am still in red by about 30% given my entry price was above $3. This is another "lesson learnt" post. 

So what can we learn from this episode?

The first lesson, which has been said but not easily executable, was to cut loss or trim. When the pandemic broke out and all aviation names would be in trouble, there were opportunities to trim but I did nothing. I was cowering my head in the sand because it was too painful to face the situation and think. I should have written this post back then and come to the simple conclusion that trimming will give me firepower to buy more later.

Instead, I did other silly things are trimming winners and cutting other stocks that are less well-loved (only to see them rebound 100%). Yes, this name is one of my favorite, a rare Singapore stock. I couldn't bear to cut. This is the analyst's cardinal sin - do not fall in love with your stock. This is the second lesson.

Accelerating transformation!

Okay. Now that we have learnt our lessons, it is pointless the dwell on the past. It's time to look forward while remaining vigilant on how we can reshape our portfolios (the consistent message from SIAEC's investor materials!). There are two points to discuss: SIAEC's management and the future of aircraft maintenance.

This pandemic has reiterated the point that SIAEC's management is very good. They managed to steer the company into minimal losses and stayed FCF positive. Both the Chairman and CEO are recently appointed and yet they were able to lead decisively through the pandemic. As such, it means that the DNA of the firm is simply strong, capable of making the right decisions more often than not, allowing the firm to navigate the pandemic better than others. 

The future of aircraft maintenance is harder to determine. Before the pandemic struck, one school of thought postulated that maintenance is in structural decline. Technology has improved and there is little need for expensive checks. More downtime means less time to fly passengers around. Well, with the pandemic, the trajectory has changed. There could be a strong recovery first before we talk about decline. But we also know air travel will not decline over the long run. The pandemic can stop us for two years, three years but not ten, fifteen years. Just look at Singaporeans traveling all over world the first chance we got!

Recovery in sight but there is a range of uncertainty!

SIAEC's chart above showed management's view of the recovery trajectory. From this, we can tell that management is thoughtful about their business while the future remains uncertain. While passenger traffic can grow, maintenance could be a different story. The saving grace is that SIAEC has JVs all over the world generating c.S$4bn of revenue cumulatively (via its JVs and its own businesses on an annual basis) and was instrumental in its strong performance during the pandemic. So, even if the whole industry goes into decline, SIAEC can continue to gain share. 

But let's not get too excited. Remember the cardinal sin? There is a recovery in sight but it will take a lot for SIAEC to go to S$5. After five years and losing a few thousand dollar and a little wiser, the new range of IV could be closer to $3-3.5. This is derived using FCF of S$150m and giving it 20x and add its S$500m on its balance sheet, its intrinsic value is c.S$3.5bn. With its share count of 1.12bn, this works out to be S$3.1. Using more optimistic no.s would put that to S$3.5. So we have 40-60% upside while the downside should be $1.6 (-40%) at the height of the pandemic. 

I will be taking profit when it hits $3-3.5. 

Happy Valentine's Day! Huat Ah!

Charts #43: The World

I check in with visual capitalist once in a while. I would recommend all investors do the same. This chart is worth scrutinizing and see how it will change 10 to 20 years from now.

Jim Rogers famously said the 21st Century belongs to Asia. Well, look like we still need to grow. We are counting on India now!

Do check out the visual capitalist, they are awesome!

Happy Chinese New Year, huat ah!

Books #16: The Man Who Solved the Market

The Man Who Solved the Market is one of the best books I have read in 2021. This is the story of Jim Simons, founder of Renaissance Technologies, the world's most successful and most secretive quant fund. Even after the book is published, nobody knows exactly how Renaissance made so much money. The table below from the book says it all.

Jim Simons vs all gurus

These no.s are net of fees and the annualized returns before fees are above 50%, which means doubling the capital every 18 months or so. When so much money is being made so fast, it is no wonder the whole Renaissance team doesn't want anyone else to know the secret sauce nor are they interested in sharing. 

So we can only speculate how things actually work.

The details are scant. The book shared a couple of facts:

1. You need a lot of data for quant models to work and as such there are thousands of trades implemented at any point. Every trade is analyzed. It took decades before the team perfected their trading wins.

2. Trades at tested using mathematical / quantitative models, looking for correlations and robustness. Trades are based on math theories that may not have anything to do with economics or business fundamentals. Renaissance doesn't look for relevance or explanations.

It works because there are always anomalies that continue because humans are simply not rational. One of the most simple ones are traders and fund managers closing trades at the end of week or month, Renaissance takes advantage of that and reap the small returns by taking the other side. But most of time, according to people quoted in the book, they cannot explain fundamentally why some trades work, but that is okay.

The other revelation is that only slightly more than 50% of the trades are profitable. Although it is not stated in the book, it means that one the most important rule in trading - cutting losses, works. I learnt it while reading about the turtle traders. Their rule: as long as you cut loss at say 2% and let your profits run at double of that i.e. at 4% and above, you can win even if you only win 50% of the time. 

Besides getting the taste of the secret sauce, or rather more of a whiff of smelling it, what is also interesting is how the book weaved the whole history of the financial markets for the general reader. It talked about the turtle traders, the 1987 Oct crash, George Soros vs the Bank of England, LTCM, a few flash crashes caused by quants over the last two decades, needless to mention - the GFC and all the other important financial moments over the last 60-70 years. 

That was really just nostalgic for me and perhaps very educational for new students of finance.

It is worth noting that LTCM tried to do what Jim Simons did and blew up. So, in essence, Jim was the successful LTCM and when he succeeded, he stay hidden so that his team can continue to reap the profits from the anomalies. There is some value in maintain secrecy when you do have an edge as exemplified by Renaissance, KFC (Colonel Sanders' secret recipe), Coca Cola and famously in Japan: FANUC, the company that invented the numerical controllers for machine tools and robots.

The last bit of the book talks about how Renaissance employees managed to influence politics. Notably, one of the key staff allegedly supported Trump and got him into the Oval Office using his money and influence. It is a testament that big money is so powerful that it can decide politics and impact our lives.

COVID-19 to Omicron: Three Years On

When the pandemic broke out in 2019, we had no idea how crazy this could get. I have always been a fairly optimistic person and I thought we should be done in 12 months, if not 18 months. The world will quickly revert to normal because humans are creatures of habit and we like to go back to our old ways of lives as soon as we can. This is why losing weight is so difficult and why we cannot really change and become something we are not. 

We are entering the third year into the pandemic now and things are not looking optimistic. New habits are now being formed which may replace old ones permanently. For instance, we may not need to meet everyone face-to-face going forward. Zoom or virtual meetings can easily become say 60% of all our meetings and old style phonecalls may still make up 20%. So the last 20% of face-to-face meetings will be saved for the most important, most precious counterparties.

The big question is whether we will still fly as we used to. When the pandemic first broke, the airline industry quickly made a prediction: we will only get back to 2019's level of passenger volume by 2025. This was based on the experience from the 9-11 attack back in 2001. At first, I didn't want to believe that. We are so used to flying, how can that be true? Three years on, it now seemed likely, or perhaps, it could take even longer, since we are still only at 40-50% of 2019's levels.

Flight traffic comparison - courtesy of Flightrader24

This does not mean we will not travel anymore. It's the same as zoom or webex. We will save up for the best. We will still travel for leisure for sure. That's the first thing Singaporeans did! We are all not in Singapore now having not being able to travel for the last two years. Business travel should revert to some kind of new normal. For some, it could one less trip per year i.e. dropping for 4 to 3. For frequent flyers, it could be 10 to 8. But I believe, over time, we will surpass the previous peak. It is just whether it's 2025 or 2030. 

It may be just numbers (of years) to most of us, but to the airline industry, it's big difference. Our beloved carrier SQ or Singapore Airlines (SIA), continues to burn around S$300m every quarter and if it is going to drag on, they will need money again (it raised S$8 billion last year). Similarly, aviation related plays will continue to be affected. It is amazing how SIA is now S$5 after a massive 50% dilution. At one point it was even close to S$6 which was just a tad away from the share price (S$6.4) before the dilution! How can the stock be diluted half revert to its old price in a matter of months, when the pandemic that caused the whole situation is still with us? Sometimes the market just doesn't make sense.

SQ continues to burn money

 

As such, my belief is that SQ is overvalued now, even if we actually start to recover now from COVID-19, we may not have enough margin of safety for this name. But for other SG stocks, there could be. One name that comes to mind is Jardine Cycle and Carriage, which I have also discussed previously. It has been badly hit by the pandemic and has not rebounded. Partially because it is operating in Indonesia, an emerging country will limited bargaining power for vaccines, medicines and with its domestic consumption still weak, with no recovery in sight.

Similarly, there are many recovery plays that could be interesting: restaurants, cinemas, domestic tourism names in other countries (not so much Singapore) and we should think hard to find these names. On the flipside of the coin, we should be worried about pandemic positive stocks, like zoom and other SAAS names, that had done really well. Some of them have already collapsed, but we may not see it bottoming yet because valuations are still sky high. Just look at Peleton (below), the Netflix + stationary bike manufacturer.

Peleton's share price

At the height of the pandemic, everyone wanted a Peleton bike. The market cap was a crazy US$50 billion. It has fallen 80% but still it's US$12 billion market cap, which is bigger than SQ! This is a company with no earnings, no track record, no cashflow. Just the idea that you can watch motivation exercise videos and cycle to lose weight, which was the best thing ever when everyone was stuck at home. But what happens when we can go out again?

We live in the most unusual times. The GFC created the new paradigm shift to zero interest rates which caused asset prices to inflate through the roof. Some of this huge monetary expansion finds its way to fund startups and created giants (Gojek, Tiktok etc) in the span of a few years. Then the pandemic hit and we saw how it accelerated the growth of some of these co.s but decimated segments of the old economy.

In the midst of all this, we now have real world inflation, a possible bubble of everything and potential recovery in some covid-hit names. But we have to exercise caution because all this is not going to end well. We can only diversify (not so much into cash but different holdings, perhaps even crypto - topic for another day) and hope for the best!

Happy 2022, huat ah!

Berkshire Hathaway in 2020-21

I have invested in Berkshire Hathaway for a decade or more based on the most simplistic investment thesis: this is Warren Buffett's company and he is the world's greatest investor. There was very little further due diligence after that. So is this investing or speculating?

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." - Ben Graham

To satisfy Ben Graham, Warren Buffett's teacher, this post is a quick dive into of Berkshire Hathaway.

Here's a few numbers which should be read as average over the past few years:

Revenue c.USD250bn

Cashflow from operations c.USD40bn

Capex c.USD15bn

Free Cashflow c.USD25bn

Total assets c.USD870bn

Total equity c.USD440bn

Based on news report, Berkshire has rebounded with a 7% increase in overall profits with some of its businesses exceeding pre-pandemic levels. Cashpile is close to USD150bn and total equity portfolio has also rose to USD308bn and its market cap is now USD650bn.

Berkshire is the lifework of the world's greatest investor. It has compounded its value over the last 50 odd years, and should continue to grow its intrinsic value beyond Warren Buffett and Charlie Munger.

Merry Christmas and Huat Ah!

Charts #42: Offshore Wind

 This is an interesting chart from the Economist last month. Optimal offshore wind locations are at a certain latitude and we just need to build 500k offshore wind turbine to contribute to 7.5% of global energy output.

Offshore wind

Well, we are not starting from zero, we have 7,000 today. And to power the whole world, we just need to 7 million wind turbines at these optimal locations.