Monday, August 09, 2010

Divestment of FSL Trust

I guess this was an action which should have been taken some time back, but trust me to allow inertia and false hope to dull my thought processes, rationality and objectivity; thus causing me to delay my decision to completely divest First Ship Lease Trust (“FSL Trust”). For the record, I have completely divested my position in FSL Trust on August 3, 2010 at an average price of S$0.41125, crystallizing a realized loss of about S$14,000 (or about -64%). If dividends of S$6,300 are taken into account over the years, the actual loss from this investment stands at S$7,700 or about -35%, still nothing to sneeze about. Since I had recognized realized gains from dividends under realized gains/losses in my portfolio review, I shall now take in the full S$14,000 loss there to offset the $6,300 recognized over the years (as per proper accounting procedures).

Let me categorically state right now that even as early back as mid-2008, I was “warned” about the structure of Shipping Trusts and of FSL Trust in particular as being vulnerable and unsustainable. An expert and very detailed forum poster by the nickname of d.o.g. (Disciple of Graham, no doubt) pointed out that a shipping trust could be evaluated and valued based on a DCF (Discounted Cash Flow) basis, since its cash flows were “supposed” to be predictable, stable and consistent. When he ran the model through using an appropriate discount rate, it was discovered that the discounted cash flow value of FSL Trust was less than the share price at the time (above S$1.00). I chose to ignore that pertinent piece of advice at the time as I was indignant and obstinate and wanted to prove that the Shipping Trust model was sustainable and that the value of the cash flows would grow (through M&A of vessels) over time to render the original DCF analysis invalid. All I can say was that it was a very expensive piece of advice to ignore, and if you count in the opportunity costs of having the capital invested in FSL Trust, then the mistake is sadly compounded many times!

In some ways however, the decision to divest has been long overdue and it is actually a big relief for me to be finally rid of this investment, which has been providing perennial headaches and problems for the past 1.5 years (since the global financial crisis hit the shipping industry hard). The point here is that there is no logic or sense in holding on to a sinking ship (mind the pun) while letting your capital languish; hence I saw the opportunity to free up this capital and reinvest it into a more worthwhile company. Considering my investment in FSL Trust was made in January 2008, a time when I was in transit with regards to my investment philosophy and a “virgin” learner in the value investing field, I guess I probably made some “classic” mistakes and committed several easily avoidable cardinal sins. These mistakes have been thought-out by me and will be detailed below for future reference in order for me to learn and avoid making the same errors again.

1) Not understanding the risks fully (e.g. LTV Covenants Clauses) - One of the basic rules in investing is that you should fully understand the investment you are making, or at least the important aspects of it so that you are not caught by surprise. Apparently, I had read up on shipping trusts in a cursory way and did not delve deeply into the details of LTV clauses and interest reset clauses, which conveniently kicked in when ship values plummeted along with the crisis. There were other risks such as counter-party risk which was perceived to be low at the time because “times were good”; but which came back with a vengeance to “haunt” the Trust recently (when Groda Shipping defaulted on payment for NIKA I and VERONA I). Some investors mention that of the three shipping trusts, only FSL Trust has a full-time risk officer; but then again a risk officer is quite useless when the risks cannot be foreseen or properly mitigated! At the time the Trust was constituted, no one could have predicted the kind of severe fallout in the industry which would severely depress values of ships.

2) Under-estimating the downside, over-anticipating the upside - A classic case of investor myopia. When times are good, people (including myself) can only see clear skies and a nice breeze ahead; and no one even imagines there will be storm clouds, thunder and a lot of lightning! I recall very clearly that during the AGM for FSL Trust held in April 2008, investors were talking about “yield compression”, which essentially implied that the share price would move up to reduce the yield which was then a high 9-10%. Of course, no one could foresee that instead of the share price moving up, the yield went down instead…..

3) Overly aggressive payout (initial was 100% payout) - Warning bells should have rung loud and clear when it was declared that FSL Trust would have a 100% cash payout and not retain any cash for paying down loans at all. Back then, the loan was structured as a “bullet” repayment in 2012 and was not treated as an amortizing loan (which required regular repayments similar to a mortgage loan). This overly aggressive payout ratio meant that Management was more focused on the short-term rather than the long-term viability of the Trust, as they did not create a buffer for the Trust in case something went wrong (and true to Murphy’s Law, something DID go wrong, as we can all see from hindsight). I even recall a shareholder questioning the rationale for Management to pay out 100% while passing a resolution to raise funds through issuance of new units; and the reply given by Philip Clausius (if I recall correctly) was that Management wanted to maximize returns to shareholders. In the end, Management were forced to reduce payout ratio from 100% to 70%, then to 50% and to the current 33%. With no end in sight to the crisis, bank loans being due in 1 to 2 years time and having two vessels on the spot market instead of long-term charters, it would seem that payout ratios may dip even further in future.

4) Ships as depreciating assets; unsustainable business model which requires either fund raising or debt issuance - It has been argued on many forums that shipping trusts are inherently inferior to property trusts (known as REITS) as ships are depreciating assets whose values MUST go down over time, while properties will retain a significant portion of their value even through the passage of time. The opponents of shipping trusts feel that this makes shipping trusts unsustainable as investment vehicles as the Trust must continually raise funds to acquire new vessels which are accretive to DPU in order to sustain the payout. In time to come, this can only mean more debt to buy vessels, or else a secondary offering of securities to raise funds (which dilutes existing shareholders). A rights issue would totally defeat the purpose as a Trust is supposed to pay out cash, and not suck it back from unit-holders!

5) Loan bullet repayment in FY 2012 - On hindsight, I would conclude that the Trust was setting itself up for trouble when it agreed to a “bullet” one-off repayment of its loan by 2012. This was on the assumption that it was either able to raise enough funds to pay off the loan by then, or it could roll over the debt by posting up more vessels as collateral. Both options did not materialize and I can safely say that the Trust will now have a major headache come 2012 as it mulls over how to settle its debt obligations. They should have structured it as an amortizing loan in which they pay down the debt progressively, while reducing their payout ratio to say 80%.

6) Risk mitigation is close to impossible - Despite having a stringent screening process, a risk officer and many levels of review before selecting a lessee for their vessels, FSL Trust still experienced a client default by Groda Shipping. Its ships were arrested and had to be put up in the spot market for spot charter. Risks are very tough to mitigate in the shipping industry as the industry itself is cyclical by nature, which means that companies may seem healthy and fine during good times, but will struggle to survive during bad times. It is a known fact now that the global crisis caused several shipping companies to go bust; while NOL reported a whopping US$700 million loss in the previous financial year (at the nadir of the crisis).

7) No visibility in terms of cash flows, more costs may be incurred for lawsuit and other associated costs relating to VERONA I and NIKA I - The default by Groda Shipping was the tipping point in terms of my decision to finally divest, as this meant that there was no more reliability in the cash flows for the Trust and it should be noted that the Trust has stopped providing forward guidance on DPU. Up until 1Q 2010, they were still guiding for US 1.5 cents per unit DPU; and it was only recently that this dropped to US 0.95 cents due to the default. Other future costs may be incurred for lawsuits and guarantees to be posted on the two vessels, and this clouds the visibility for future payouts. The point of a Shipping Trust is to have predictable and stable cash flows for the unit-holder. Once cash flows become unpredictable and inherently unstable, I do not see the point for staying vested.

8) Go for sustainable yield even if it is moderate, rather than for high yield which may not be sustainable in the medium-term - Another classic mistake made by me was the constant chase for high yield, so much so that the risks are blindly ignored in the process. The key is to look for sustainable yield rather than high yield; thus I am willing to accept a dividend yield which is higher than inflation but I have to be assured it can be sustained.

9) Yield is about 4.5%, but risks are high due to leveraged balance sheet and consistent pressure from bankers (at the mercy of bankers) - The yield for me for FSL Trust has fallen to about 4.5% (using US 0.95 cents as a gauge), but with the highly leveraged Balance Sheet and the fact that the Trust is subject to the whims and fancies of bankers (for LTV Covenants, advance payments to “appease” the banks, and stuff like market disruption clauses), this makes investing in FSL Trust particularly unsettling and worrisome. In short, it does NOT give me a good night’s sleep and I can find assets which yield a similar level of dividend yield which would probably allow me to sleep much better. Hence, I can safely conclude that it was the sharp decrease in yield which has contributed to my decision to divest too.

10) Risk of DPU becoming lower in future periods due to LTV covenants, debt repayment issues and vessels on spot charter - There is a further risk of DPU further declining in the face of many uncertainties, such as LTV ratio, vessels on spot charter, and legal wrangles for NIKA I and VERONA I. Not to mention the fact that the bankers also need to be paid their interest; and the impending bullet repayment in FY 2012, all this comes together to make up a “perfect storm”.

11) Unable to raise financing during Dubai Crisis indicates lack of attractiveness - The fact that the Trust was unable to issue bonds as a result of the Dubai Crisis also indicated that they did not have much bargaining power and clout. Of course, some may argue that it turned out to be a blessing in disguise as the bonds were to have an 11%-12% yield, so how in the world could you have accretive acquisitions when you are paying through your nose for interest expenses (yes, to the same bankers, no doubt)?

12) Recent attempts to acquire a vessel have also fallen through (no potential accretive DPU acquisitions) - FSL Trust’s recent attempt to conclude the purchase of a vessel had fallen through (as per the audiocast session Q&A). This further puts a spanner in the works and reaffirms my belief that the business model is inherently flawed.

13) Relatively new business model (shipping trust), IPO was too recent and no track record or stability of performance - In fact, the only comparables were to the two (also newly listed) shipping trusts Pacific Shipping Trust and Rickmers Maritime Trust. The more established Shipping Trusts were Seaspan listed in the USA, but even then this was not a proxy for stable performance as the Trusts had all yet to undergo “hell and high water” conditions. Only if they had survived through downturns and recessions and emerged unscathed (or even stronger) can we conclude that the business model is sound and can stand the test of time.

14) Weakening USD:SGD rate also does not boost dividends once converted into SGD as dividends are declared in USD - This may sound like a minor point but it also contributed to the frustrations and resulted in lower dividends for me.

In conclusion, the above points were the culmination of much rumination, analysis and critical thinking on my part over the course of many weeks (and even months actually). I certainly will keep the above lessons in view and judiciously avoid repeating them again for my future and current investments. The capital released from the sale of FSL Trust will be deployed once a suitable investment opportunity is found.

24 comments:

Createwealth8888 said...

This is a good example of high dividend yield trap. We all love high dividend yield stocks but sometime we need to ask is the high dividend payout ratio of 80% or more sustainable?

Royston said...

Guess its always painful to have to cut loss, even though it makes sense to do so.

I think alot on investment is also about avoiding costly mistakes than looking for supernormal gains. I personally got burnt by Fibrechem as well, where i suffered a 100% loss. Though it taught me not to just look for "cheap" stocks which have fallen alot. As it can always fall further, sometimes down to nothing.

But fortunately, its also not necessary to be always right in investment...some mistakes will still put you in good stead as you learn from them.

Musicwhiz said...

Hi Createwealth8888,

Yes, I agree with you on the dividend yield trap. I got caught like a fly in a spider's web, haha.

But to be honest, there were other such investments which "trapped" the hapless investor too, such as Babcock and Brown Structured Finance Fund. And I also recall MacCook facing some problems of its own as well. Guess the global financial crisis showed up who was swimming naked.....

Cheers,
Musicwhiz

Musicwhiz said...

Hi Royston,

Yes, it's painful but in a sense a lot of the forceful impact was already past (when it fell from $1.00 to current); so much of the emotional impact was long gone. So I really didn't feel much "pain" when I sold; in fact I was quite eager to re-deploy the capital!

Sorry to learn of your loss in Fibrechem - I guess "S" shares taught many of us a lesson in terms of corporate governance and integrity.

And you are right - you don't have to be 100% tight (in fact it's quite impossible). Peter Lynch says a 60% success record is considered good enough; but my view is that we should keep mistakes small, while ensuring our successes continue to generate good income for us.

Thanks!
Musicwhiz

Chin Yee Hong said...

Hey, do you know what happened to Afralug forums?

Musicwhiz said...

Hi Yee Hong,

Afralug forum is down, as far as I know. Since I am not the Admin, there's nothing much I can do about it. Let's wait and see what happens.

Regards,
Musicwhiz

Wei Sze said...

hi there, i came across your blog recently and i just want to say thank you for all the sharing you have done! your learning is also helping someone else (me that is!) to learn.

thanks for the informative read! Jia You!

Musicwhiz said...

Hi Wei Sze,

Thanks for visiting and I am really glad I could help you to learn more through my mistake. It's good to know my blog benefits others who may wish to avoid the silly mistakes I make. Haha.

Cheers,
Musicwhiz

left_ray said...

I read your rational of buying FSL couple years ago and thought it was a good investment. Because I also bought FSL. Of the three shipping trusts, a lot of people like FSL because of its diversity and high yield, except OCBC. They were spot on with the flaws of FSL and this year they cease to analyze shipping trusts. Is it really that bad? I don't know if my analogy is correct or not. Production equipments also depreciates, but as long it can make goods, it still can generate income. How about vessels? Anyway, its now a high risk investment and people are losing faith in this sector. Divestment is a good idea. But, I am still unwilling to let go.

Musicwhiz said...

Hi left_ray,

Well, to be honest things change and sometimes they change a lot! 3 years ago things were still rosy and ginger peachy with the shipping sector, so unwittingly I bought into the Trust at the high! I guess I've said enough in my commentary on my blog, but let me just add that I did "stick around" even after the major crises hit to see if FSL Trust could dig itself out of the hole. Apparently, they have not and are still stuck in the rut.

There are probably better companies out there with more consistent operating histories giving very stable dividend yields, so I am going to search for those.

Oh yes, it's NEVER easy to cut loss - I've been through it many times before and now I've learnt to ignore the emotions and focus on growing my funds. In that sense, it's a relief to divest so I can redeploy the monies. The decision, though, is ultimately up to you. Good luck!

Cheers,
Musicwhiz

JK Holdings said...

With the current price of FSL, it is quite attractive.... I think high dividend payout give pressure for FSL themselves.... any quick rebound to 60 cents is highly possible...

Musicwhiz said...

Hi JK Holdings,

You may have to substantiate your case further as to why FSL Trust is attractive. Hope to hear from you on more details, thanks!

Regards,
Musicwhiz

Createwealth8888 said...

Know how to buy. Know how to sell.

Be a willing buyer and seller.

Don't let market force you to sell unwillingly out of either frustration or hopelessness.

broken clock said...

I had informed Azlan about the problem at afralug forum. He said that the server has crashed and he is doing his best ro get it up.

But,that was a week ago and he has not gotten back to me yet.

Rose said...

I am rose anderson ,I read your article you really provide a good info how to minimize risk and increase your return in the uncertain market condition.Investment is risky factor,second thing is big profit expectation means big chance of loss .Right and proper use of fund prevent your investment from fluctuating market risk.You basically give a good info in your article.I want to upload one article in your blog related to investment in return I can also upload your article or link in my site and blog.I have few finance sites and blogs.... we both can do some link or article exchange in order to increase our web presence and in return we both can increase our site's ROI.

Please reply me if you are interested.
roseanderson26@gmail.com

Musicwhiz said...

Hi Createwealth8888,

Don't worry Mr. Market is just there for me to transact, I will do my best not to fall under his influence! :)

Cheers,
Musicwhiz

Musicwhiz said...

Hi Broken Clock,

Oh thanks! Do you happen to have Azlan's email? You can contact me through musicwhiz55@gmail.com to tell me more about the status of Afralug, if you will.

Thanks again in advance!

Musicwhiz

Musicwhiz said...

Hi Rose,

Thanks for the offer but I would like to politely decline.

Regards,
Musicwhiz

AK71 said...

Hi MW,

I probably got into FSL Trust at about the same time you did.

I wrote a piece on FSL Trust on National Day and would like to share it here with you:

http://singaporeanstocksinvestor.blogspot.com/2010/08/fsl-trust-where-to-from-here.html

Wish me luck. :)

Musicwhiz said...

Hi AK71,

Thanks for sharing - I read your article! Good luck!

Cheers,
Musicwhiz

JK Holdings said...

In view of FSL, I comment purely base on chart, I think 60 cents is the next resistance point... Anyway, that's just purely based on TA.. Good analysis on all the stocks that you have invested.. benefited some from it too .. :)

Musicwhiz said...

Hi JK Holdings,

No problem, glad you have benefitted.

Cheers!
Musicwhiz

Newbie Investor said...

Hi musicwhiz,

Have you ever considered to continue holding FSL? It may simply be a rough patch that it is going through. At your purchase price, the yield is still quite decent.

Perhaps you can consider adding more reits into your portfolio? What your views on aims amp reit and cogent holdings? These 2 are considered dividend stocks.

Musicwhiz said...

Hi Newbie Investor,

As mentioned, it's not the matter of the yield being decent; but whether I can get a good night's sleep without worrying what's going to happen next with the Trust. Assuming I can find another investment with less problems, lower or no debt repayment issues and the ability to generate good FCF; yet paying a similar or better yield, it would make sense to switch. For FSL Trust, cash is a previous commodity as bankers are hounding for repayment of debts, and at current depressed unit price it will not be accretive to raise funds through a secondary placement for purchase of distressed vessels. Debt is obviously not an option either as they are already heavily leveraged. So this means they either have to cut the dividend or use DRIP to ensure they conserve cash. This creates a lot of uncertainty for me (hence sleepless nights).

Am currently not looking at pure dividend plays, but more a mixture of capital gains and decent dividends. Will update more in my month-end portfolio.

Regards,
Musicwhiz