Friday, January 30, 2009

January 2009 Portfolio Summary and Review

January 2009 saw a continuation of the financial turmoil which engulfed the major banks throughout 2008. Citigroup has now officially split into two divisions – CitiCorp and Citi Holdings, while selling their brokerage Smith Barney to Morgan Stanley (thanks to comment by dream for this correction). Bank of America also saw a much needed bailout and in the UK, RBS reported a massive loss of €28 Billion and together with Lloyds and Barclays, needed a lifeline from the UK Government. It would certainly seem that the end of trouble for the banks is far from done, as more and more write-offs appear and banks are still urgently in need of capitalization to strengthen their Balance Sheet.

What I personally feel angry about is how the banks managed to wind up in this massive mess. Those who had been following the progress of this major financial crisis would have known that the trouble started from the sub-prime mortgages and CDOs, and gradually spread to other classes of debt and resulted in massive write-downs on illiquid assets. The problem is more insidious than this of course, and involves not just the banks doing lax lending (to mortgage home owners who could not pay up), but also the rating agencies such as Standard and Poors and Moodys which rated these complex debt securities as Triple-A ! I shudder to think of the amount of greed and oversight that must have occurred for such massive financial bailouts to be carried out by Governments in developed countries. One thing’s for certain – the financial system would require an entire overhaul and new regulations set in place after this crisis recedes, to ensure such events do not play out again and wipe out the wealth of millions worldwide.

The wave of corporate failures is piling up, with Jurong Technologies being the latest victim of statutory demands served by a total of six banks. In addition, many companies have been announcing profit warnings as the crisis hits demand for goods and services and causes sales and profits to be drastically reduced. In the real economy, layoffs are also being announced by local companies as well as MNC with Singapore operations, with Microsoft shocking the world by announcing the layoff of 5,000 workers. More retrenchments are set to follow as our Government has warned of worse days to come and to brace for the storm.

Singapore has unleashed its boldest Budget to date as the Government dipped into our National Reserves for the first time ever, to come up with a fiscal stimulus package to save jobs and to pump prime the economy. Assistance was also given to families and wage-earners to help them preserve jobs and to put food on the table, but sadly I felt more could have been done for those who had already lose their jobs as Singapore does not have a welfare system in place (the closest is “workfare” but this means you need to have a job to enjoy the benefits !). It remains to be seen if the Government would introduce more off-budget measures to boost the economy and help citizens if the recession worsens considerably as 2009 progresses.

In terms of corporate activity, January 2009 was another slow month (unsurprisingly) due to the worsening of the global crisis. It has become much harder for companies to secure new business as most sectors and industries are grinding to a halt as financing becomes harder to secure. FSL Trust, Ezra and Suntec REIT announced their results this month and are briefly summarized under the respective company headings.

For February 2009, I would be expecting the results announcements of my remaining companies; being Boustead (3Q 2009), Tat Hong (3Q 2009 to be announced on Feb 13, 2009), China Fishery (FY 2008), Pacific Andes (3Q 2009) and Swiber (FY 2008). My expectations are for all my companies to announce a fall in profits year-on-year, as the turmoil has probably affected all of them adversely. The most important aspect for me, however, is to monitor their cash flows and future plans to tide through this recession. Of course, any dividends declared would be an added bonus, but it should be at the expense of retaining cash to tide themselves through this difficult period.

1) Ezra Holdings Limited – Ezra their 1Q 2009 results on January 14, 2009. Recurring net profit was up 260% from US$2.6 million to US$9.3 million year-on-year, as a result of more charter revenues from an expanded fleet, as well as contributions from their Energy Services Division. Note that the net profit comparison is after removing the effects of the unrealized exchange losses for both years, as the Company had foreign exchange balances denominated in NOK which were subject to revaluation at period-end, resulting in the exchange loss. Keppel Singmarine is still in negotiation with Lewek Shipping on the cancellation of their MSFV contract, and more information should be provided in February 2009. The Company has reported decent operating cash inflows though capex at this stage is still high, but with the overhang gone on its MFSV newbuild program, this situation should gradually be alleviated. Moving forward, the Company should conserve its cash till visibility improves for the oil and gas sector. No further analysis will be done until they release their 1H 2009 results some time in April 2009.

2) Boustead Holdings Limited – Boustead had announced, on January 15, 2009, that their Energy Services division had secured contracts worth S$65 million, including one in USA for which they had scored their maiden contract. It is heartening to know that the company can continue to secure business under difficult conditions, and I look forward to an update by the Company on various aspects of the business in their 3Q 2009 results release next month.

3) Swiber Holdings Limited – There was no news from Swiber at all for January 2009, and the lack of updates for the third sale and leaseback is particularly worrying. It is possible that financing could not be readily secured for the vessels, which is resulting in this unreasonable delay. Also, the company has not announced any new contract wins for the last 3 months, which is a sure sign of the swift deterioration in business conditions during the last quarter (their last LOI announcement was in October 13 when they announced breaking into the Indian sub-sea market). However, a quick check on 2008 showed that most of the contracts and LOI were secured in the period from early February till late March, so until this period has passed, it will not be possible to pass such quick judgement that the Company is unable to secure new business.

4) Suntec REIT – Suntec REIT announced their 5Q 2008 results on January 23, 2009 (they changed their year-end from Sep 30 to Dec 31). The DPU was 2.858 cents per unit, giving me an annualized yield of about 10.3% at my purchase price of $1.11. No further analysis will be done on this REIT as it constitutes less than 2% of my entire portfolio.

5) Pacific Andes Holdings Limited - There was no news from PAH for January 2009. Their 3Q 2009 results are expected in late Feb 2009, and I am bracing for a further drop in profits as export trade and SCM activities slow down due to the ongoing financial crisis.

6) China Fishery Group Limited - There was no news from CFG for January 2009, and their full-year 2008 results are expected to be announced in late Feb 2009. Hopefully, the Company will declare a decent final dividend. I am expecting a dividend of 2 cents per share as the Company may have to conserve cash amid the sharp recession and drop in export activity.

7) First Ship Lease Trust – FSL Trust released their financials on January 21, 2009 and declared a DPU of 3.08 US cents per unit. Using a conservative exchange rate of 1.45 SGD to the USD, DPU is about 4.466 Singapore cents per unit which translates into an annualized yield of 16.24%. However, FSL Trust announced that payout would be reduced to about 2.45 US cents in 1Q 2009, as a result of them wanting to conserve cash to repay debt. The financial turmoil has caused my investment to suffer a permanent financial loss due to the collapse in the shipping market, which has raised the risks of client defaults and breach of loan-to-market value covenant. Though I will continue to monitor FSL Trust as the quarters pass by, I am very much prepared to acknowledge this investment as a major mistake.

8) Tat Hong Holdings Limited – Tat Hong announced a profit guidance on January 15, 2009, stating the profits for 3Q 2009 would be lower than the corresponding 3Q 2008 due to unrealized forex losses due to the purchase of inventory in JPY (and hence revaluation of creditor balances as at period-end due to strengthening of the JPY against SGD); as well as a drop in business demand due to the ongoing financial conditions. I can safely say that this profit guidance was more or less expected by me and I am even projecting a possible 4Q 2009 and FY 2010 profit guidance for lower profits due to the deep recession. However, with the Singapore Government announcing fiscal measures to boost infrastructure spending and the release of projects for the construction sector, Tat Hong could possibly benefit from this. I remain cautiously optimistic on the Company’s medium-term prospects amid difficult business conditions.

Portfolio Comments – January 2009

January 2009 saw a much more subdued stock market with less volatility, though sentiment did not improve much at all. My portfolio has dipped from a total loss % of 25% as at end-December 2008 to 30.3% as at end-January 2009; but thankfully was still better than the -34.5% registered for November 2008. Part of this loss was offset by dividend from FSL Trust and Suntec REIT (both to be received on Feb 27, 2009).

My next portfolio review will be on Saturday, February 28, 2009.

Wednesday, January 28, 2009

Investing Like an Ox

Let me take the opportunity to wish all Chinese readers a very Happy Lunar New Year, and to usher in the Year of the Ox ! It's somewhat appropriate that this year happens to be the year of the Ox, as I seek to revisit some of the classic investment and wealth-accumulation principles which has served generations of human beings, and will continue to act as a guiding light for investors during times of darkness and gloom. In Lord of The Rings terminology, it simply means the Light will eventually conquer Mordor and the Ring of Power will be forever destroyed !

So what is it about the Ox which has traits for us to learn and emulate ? For starters, the Ox symbolises patience, (good old) hard work and discipline. Along with those attributes, the Ox also conveys steadiness, resilience (as in "Resilience Package" - the name of this year's Singapore Budget !), dependability, calmness, being methodical, tirelessness, perserverence and the capability to endure hardships. One would argue that these are old-fashioned axioms which our fore-fathers would have smiled upon, as they hark back to the olden days even before computers and handphones existed. This is what investing should be about, and I shall elaborate more in the subsequent sections.

Of utmost importance is patience and perserverence in the face of adversity. The Ox is known as a beast of burden and is put to work in fields under the hot sun, toiling day and night. It is only with lots of patience and perserverence that the Ox is able to complete its task, all the while unhurried and unruffled. As investors, we need to absorb this aspect of the patient Ox, to be able to wait for our investments to bear fruit and also to have the patience to wait for an appropriate opportunity to invest in a good company. To perservere through hard times such as these is not easy, but resilience is important for us to be able to bounce back once the crisis is over, and to remain relatively unscathed. The idea is not to make major investment mistakes which would substantially wipe out almost all our capital. If this happens, then it might be extremely difficult to claw our way back to our original positions.

Another important trait to emulate is that of hard work and discipline. The days of easy credit and easy money are over with the near collapse of the USA and UK Banking system. Punters and speculators who used to ride on the wave of easy money from following the bull trend now have to go back to basics and work hard for their returns. For investors, it's a total back to basics formula as the seemingly easy returns of the bull market have all but evaporated. Even in other aspects of life, one has to rely on hard work and discipline (in saving a portion of income) for one to be able to grow wealth slowly but surely. Wealth accumulation is a slow but steady process and the Ox is a symbol of steadiness as it stands unflinching amidst the turmoil. Only through consistent savings and the power of compounding can we begin to see the effects on our wealth, and this will take time to realize.

Finally, I would like to touch on the virtues of calmness and being methodical. We should develop a sort of inner peace within us which shields us from the daily reports of more "calamities" and companies laying people off or banks needing more government bailouts. Calmness helps in soothing the mind and tuning out the unwanted noise which permeates our daily lives. Of course, one knows that this is easier said than done ! We are living in a world where we are constantly "assaulted" by the media, which never fails to constantly remind us of the global gloom and recession through a barrage of news reports and updates. I myself am finding it difficult to stay focused amid the monstrous surge of news reports, 99% of which are negative and pessimistic. In order for an investor to be successful, he must be able to remain calm and rational. As human beings, this can be difficult but with effort, one can adopt selective retention and retain only the news which assists us in our investment decisions, and filter out the rest of the "pollution". For example, retaining knowledge of the Singapore Budget 2009 is helpful as one can know which industries are being directly affected by the Budget's measures (such as fiscal stimuli for example).

Being methodical means going through one's investment methodology in a systematic, uninterrupted fashion. This can be more difficult than it sounds. As investors, we are all prone to taking short cuts or to gloss over certain investment criteria in order to make a potential purchase look more attractive than it really is. I think I have been guilty of such behaviour myself and this can be traced to "confirmation bias", which is another behavioural finance aspect where we seek only information which confirms our beliefs, and tend to reject information which does not conform to what we seek to believe in. This can lead to the dangerous conclusion of giving an investment the "OK" when it is not worthy in the first place. Being methodical would ensure one goes through all the relevant screens before a decision is made, and enables the process to be more foolproof.

As the year of the Ox gets underway, I wish all investors good luck for their investments and most importantly, to remain in good health and good spirits !

Thursday, January 22, 2009

Is an Investment a mistake due to an Uncertain Future ?

I guess I didn't know how to describe what I am about to say, thus the very vague and clumsy title above ! But dear reader, perhaps by now you would have read about the global financial crisis, the sub-prime contagion and be bombarded by endless information about bank bailouts, auto bailouts and what-nots. This is how I define "uncertain future", and as I go along my investment journey, I realize that what confronts me as an investor is not just my ability to analyze and select good companies, but to be able to assess their future potential and survival to a certain extent. Let me elaborate further.....

As investors, our role and job is to assess the ability of companies to grow their earnings and ensure a steady stream of cash flows. Our returns will then be based on the capital appreciation of the shares (representing part ownership of the Company) as well as any dividends accrued over the years. Looking at past data is always easy and it is a cinch to crunch past numbers in order to attain some semblance of being able to identify a good company. However, the fuzzy part of investing is not in analyzing the past, but in predicting the future. Businesses are subject to constant change from a myriad of factors, and stakeholders are forever interacting with the company and altering its intrinsic value, thus I realized that the notion of "the fundamentals are still the same" is misleading; due to the fact that changes in the external environment and within the company itself would cause some degree of shift in its so-called "fundamentals".

With the advent of ths current severe economic downturn and sharp recession, visibility has suddenly been greatly reduced. It's as if 2 years ago in 2007 we were driving a Porsche in clear fine weather, but now the skies have darkened considerably, it's pouring and a fog has sprung out from nowhere to ensnare the unwary driver (investor). Not to mention that the Porsche has probably been downgraded to a battered 10-year old spluttering Ford car ! As an investor who used to be certain about the future potential of the companies I own, I suddenly find myself thrust in the middle of a dense fog with no sign of lifting, and there is no clear visible path to take. Thus, the best thing to do is to tread slowly and uncertainly through the mist, all the while monitoring the humidity and whether the mist threatens to turn into a deadly airborne plague. This analogy aptly describes what I had gone through in the past 12 months as the global financial turmoil engulfed all my companies, rendering many of their plans useless and forcing them to change course and steer clear of danger.

Going through my list of companies, Ezra and Swiber's long-term plans are now in jeopardy due to the slump in oil prices to US$40 per barrel, thus threatening oil and gas E&P into deeper waters which both companies had planned for. This caused Ezra to cancel 3 out of 5 of its MFSV and Swiber to postpone the construction of its Equatorial Driller. Boustead is affected by the oil and gas slump (even though they managed to clinch S$65 million worth of contracts recently) and also the property slump as they are into multi-industry. Tat Hong, being in the construction industry, also issued a profit warning as equipment sales weakened and the operating environment became more challenging. Pacific Andes and China Fishery are affected by the global trade slump and many countries are not importing due to trade financing drying up, thus their expansion plans may also be in danger. Last but not least, First Ship Lease Trust is the most affected as the global shipping industry has almost come to a standstill, with many vessels lying idle amid an over-supply as bulk shipping dries up. As a result, not only has the Trust been unable to grow, it has also been beset with problems such as potential client default (bankruptcies), loan to debt covenants and also loan repayments. Looking back, their aggressive payout was unsustainable in light of the worsening conditions, and the business model was flawed as I only thought about the upside and did not consider the hazardous effects of the downside. So, as a result, I burnt my backside.

So when do such events translate into investment mistakes ? As Warren Buffett said, you only know who's been swimming naked when the tide goes out, and I got caught nude quite flat out on some of my investments. For others, fortunately, I was wearing swimming trunks. FSL Trust immediately comes to mind as being my most recent and regrettable mistake as I under-estimated the risks of the business model; now I may have to wait 5 years just to break even on my investment (and that's assuming the Trust survives this downturn, of which there is slim chance). Another mistake is Pacific Andes, which I did mention in a previous comment that I had paid too much for, even though it is a good company. Its margins are too low, leverage too high and could not generate enough cash flows to justify my over-priced purchase.

Thus, I would conclude that a murky outlook does not necessarily render one's investment a "mistake", unless one assesses the facts again in light of the current circumstances and finds out that one paid too much for the risk one is undertaking. Recessions will come and go as part of a normal capitalist society's business cycle but companies which are well-prepared and dextrous can navigate the fog safely and emerge into the sunlight. Right now, I certainly hope that my prior research on the company's Management and policies can help my companies get through this unusually horrid storm.

Friday, January 16, 2009

Personal Finance Part 11 – Financial Advisors

While reading through Benjamin Graham’s seminal book on investing “The Intelligent Investor”, I was drawn to the chapter 10 on “The Investor and His Advisers” in which Graham discussed the value of financial advice given by various groups of interested parties. He names 1) a relative or friend (presumably knowledgeable in securities), 2) a local (commercial) banker, 3) A brokerage firm or investment banking house, 4) A financial service or periodical and 5) an investment counselor. Interestingly, he notes that most of these parties are either incapable of giving sound financial advice, or have a vested interest to encourage speculation (as defined in his book) rather than to promote sound investing principles. I shall go through his examples point by point, and also include a sixth category for “Internet Research and Advice”.

It is always good to remember, through these discussions, that ultimately the money invested by yourself belongs to yourself, and thus only you have a significant and emotional interest in growing your money. Others may give advice or tell you how to invest, but they can never know the pain of losing this money or the joy of growing it as they have no ownership of it (unless, of course, some part of your gains or losses directly accrues to them !).

1) A relative or friend – This is probably considered the “nadir” in terms of quality of financial advice. Notwithstanding the fact that your relative or friend could be the next Warren Buffett (an extremely unlikely proposition in any case), this kind of emotionally tinged advice is best ignored and only under very convincing circumstances should it be taken seriously; and then still to be supplemented with one’s own rigorous research as well. The problem with listening to relatives and friends’ advice is that familiarity often means the advice tends to degrade in value, as most friends tend to share hot “tips” and gossip rather than engage in long, boring discussions on valuations of companies (which are more akin to a business meeting – not a scenario likely found among friends or relatives). Friends or relatives may wish to appear helpful and concerned and thus try to “tip” one off on possible investment opportunities. Thus, it is likely that the quantity of recommendations will exceed the quality; an investor will do himself a favour by sifting through the pile and only researching and acting on those which hold more promise.

2) A commercial banker – In these present times, only bank clients with a high net worth of more than S$1 million (sometimes even S$2 million) will be offered a “Relationship Manager” (RM) to manage his or her investments. Commercial bankers these days have the role of RM or Financial Advisors in private banking departments to manage clients with large amounts of money. Thus, it is unlikely that the normal man on the street can receive such personalized advice. That said, the advice given by most commercial private bankers are also predicated upon the recommendations given to them via other departments, which have presumably a team of researchers doing ongoing fundamental analysis on companies worthy of investment. Hence, it is more like an advisor advising an advisor to advise the final client (a case of information passing through more than one channel, and hence probably losing much of its original vigor).

3) A brokerage firm of investment banking house – I think enough has been mentioned in my previous postings about the intentions and ultimate aim of brokerage firms, which churn out reports on a daily basis even when there is no coherent reason to do so ! To summarize, trading is encouraged by brokerage firms as it enhances their commissions, thus encouraging investors to “invest” is sort of shooting themselves in the foot. Hence, most recommendations put forth by such firms are of a short-term nature (e.g. one-year price targets), while others are of a technical nature (prediction of market direction) to encourage frequent trading. Suffice to say such “interested” advice is destructive to the wealth-accumulation efforts of investors, as frictional costs often leave them much poorer.

4) Financial Service or Periodical – This involves many subscriptions to so-called market timing and forecasting publications which aim to keep investors “updated” on the latest events and to forecast market movements in the next week, month or year. A lot of these magazines and publications churn out predictions which are not compared to actual results and basically, anything goes. Investors who believe such predictions are more likely to buy high, sell low as most of these publications advocate doing trading, market timing and adopting cutting losses (I’ve read some of them). And, on a side note, they are no more accurate in forecasting the future than the ordinary man on the street OR the experts.

5) An investment Counselor – I guess this would mean a financial planner, as they are called these days. The role of financial planners has been extended past pure insurance these days to also include the selling of investment products such as ILP (investment-linked policies), endowment plans and unit trusts (mutual funds). Most of them are not professionally trained to give specific advice on investment, but just to give a summary of the investment products available, and how to tailor them to a client’s retirement plans. Thus, most investment “counselors” these days do not give much counsel on what to invest in, but just supply general advice on investments and insurance.

6) Internet Research and “Recommendations” – This is somewhat akin to periodicals as they often try to forecast market trends and short-term market direction. Some websites do give pertinent investment advice but this is often simple common advice which applies to most people and is not specifically tailored to one’s age or risk profile. Some blogs and forums do offer research on specific companies but as usual, one should not trust such sites implicitly without doing one’s research.

As can be seen, the six methods above are not cure-alls for investing and earning a decent return. Graham says that most investors are better off not researching and purchasing individual securities, but instead purchase an index fund which benchmarks market returns with a very low expense ratio.

I invite readers to share their experiences in the comments box if they had used any of the 6 methods described above as a basis for investment advice or for purchasing individual securities.

Monday, January 12, 2009

Behavioural Finance Part 4 - Hindsight Bias

Initially, I had decided to discuss hindsight bias much later in this series as I had already lined up other "issues" in mind to feature before coming to this one. However, the recent market crash and subsequent bear market have caused a proliferation of hindsight bias theories to emerge, and I felt that it was time to address this very pervasive yet little mentioned topic in order to clear up misconceptions and make us all better investors.

Hindsight bias occurs when one believes (falsely) that one could or should have done something in the past with adequate knowledge only with the benefit of knowing the past (hence, 'hindsight'). I shall give one or two examples here and discuss why this condition is so pervasive and how it affects a majority of investors (including me as well, no one is immune !). As they say, hindsight is always 20/20 while foresight is legally blind, so for those who think the future is clear just by observing the past, they had better take note that this may not always be the case !

One clear example of hindsight bias is how often economists and "expert forecasters" look back and say that they knew something was going to happen, AFTER it happened ! The most recent case of course was the sub-prime debacle which has dragged global stock markets lower and caused the first synchronized global recession since World War II. Looking back, most economists and analysts now proclaim that they "saw it coming" even though I clearly remember that at the time in early and mid-2008, NO ONE saw the collapse of Lehman Brothers and the subsequent drastic fallout from the sub-prime crisis infecting credit markets and causing the credit freeze. Hindsight bias makes things in the past look as though they were "obvious" even though almost no one could have predicted the severe turn of events accurately, and certainly no brokerage firm or analyst correctly predicted the performance of the stock markets as at end-2008, with most having a bullish forecast of on average +10% ! This goes to show that the future can be notoriously difficult to predict and that most people have an inflated opinion of their forecasting abilities solely because of hindsight bias makng them over-confident (another behavioural finance trait, incidentally).

Another pertinent example of hindsight bias which I often get on my blog as well is the constant reminder that I "should have sold at the high and bought back at the low". This is the ultimate form of hindsight bias and concerns looking at past price movements (on a chart) to determine what one SHOULD or WOULD have done. It's a little like saying to accident victims (after the accident) that they should not have gone to so-and-so place so that they could have prevented the accident from occuring. The logic of this flawed argument is obvious - how could one possibly have anticipated something happening in the future and thus have done something to prevent it ? I find this statement usually very laughable, as people are implying that one can time the markets successfully and always buy low and sell high. In reality, it is very difficult to do this consistently (ask anyone who is honest), and some who had done this using valuation metrics (discussed in my previous post) would have also gotten it fairly wrong. An example is those who sold during the early bull market in the early 90's would have stayed sidelined for another 5-6 years as the bull market roared onwards till 2000. So my advice to those who always say one should have sold and bought back lower - how would you know how "low" it goes ? Assuming onoe had purchased a good company at a very good and low price some years back, there is always the chance the bear market may not revisit those amazing lows again. This will only be clear, of course, on hindsight ! In the meantime, the market-timing speculator will miss out on all the dividend payouts while he is not vested, thus reducing his potential gain even further.

As illustrated in the 2 examples above, hindsight bias is a very frequent phenomenon and is pervasive with regards to people who think they can can predict events or forecast the future. With respect to the stock market, nothing is clear and foresight should always be based on an analysis of the best available facts and figures. If one thinks that market timing is a viable strategy (i.e. sell when "high" and buy back when "lower"), then I have to caution that this is and always will be a product of hindsight bias, as one can only tell the highs and lows when one sees a historical chart of share prices.

How can hindsight bias be eliminated in an investor ? Very simple, I believe we should not expect an exceptional return on our investments, but instead be content with a decent rate of return (about 6-8% including dividends) over time. Those who expect an exceptional return will always think of selling at the highs and buying at the lows, and will always lament not doing something they should have done (a form of cognitive dissonance when it comes to actual purchasing). An act of commission is always more destructive than an act of omission, and in the stock market, one is not forgiven for not knowing what he is doing, and this often results in a permanent loss of capital.

At the same time, we should also be humble and accept that the future is often murky, and that we (as rational human beings) are trying out best under the difficult circumstances to maximize our returns and to grow our wealth. Thus, no use kicking yourself over the past and what one should have done as regret is a useless emotion. Instead, one should learn from his mistakes and face the future confidently, as lives must be lived forwards and not backward.

Tuesday, January 06, 2009

Scattered Thoughts on Valuations

With the current bear market entering its 16th month (most generally acknowledge that the bear market began in October 2007 when the STI peaked back then at the 3,800+ level), it is interesting for me to note that valuations between bull and bear markets can have such a significant gap. I have put a lot of thought into this matter over the last few days and admit that the following post is merely the result of a thought process which had culminated into ramblings of a somewhat academic nature, and thus may not have practical value in determining valuations for subsequent bull and bear markets and how these may have an impact on margin of safety and one's investment decision. Still, I will provide some insights into the qualitative (and not just quantitative) process of selecting companies for the long-term and also how to be mindful of possible "value traps" while doing so.

With the benefit of hindsight (to be touched on in a future post under "Behavioural Finance"), we can all now look back at the roaring and overly-exuberant year of 2007 when the bull market was still charging ahead. It is with a somewhat reflective tone that I can state that valuations at the time did NOT seem excessive, purely because at the time the future seemed clear and prospects looked good for the companies I owned. Therein lies the basis for the higher valuations, due to increased visibility of earnings and clear growth prospects (due to stable economies and markets), higher valuations of price-earnings were assigned to many companies in general. A reasonable person would not consider such valuations excessive in light of developments which were going on at the time (before the eruption of the sub-prime crisis in the USA), and thus could not rationally and knowingly have argued that companies were over-valued based on future earnings. One must also be aware that future earnings are never clear and most of the time, higher PER valuations are accorded to companies with expectations of higher earnings and higher growth; notwithstanding the fact that this MAY NOT materialize even under the best-case scenarios.

I recall the valuations of the companies which I had purchased in my current portfolio (excluding FSL Trust and Tat Hong) back then in 2007:

a) Ezra - About 12-14x historical PER
b) Swiber - About 11-12x historical PER
c) China Fishery - About 8-9x PER
d) Pacific Andes - About 7-8x PER
e) Boustead - About 8-10x PER

These would not have seemed excessive as valuations then had incorporated all known information on proposed future growth potential as well as events which would play out as Management had expected, to give rise to the anticipation of higher earnings. Of course, when the crisis broke out, suddenly the future became much less clear and the original growth prospects were not as clear or obvious as before. The credit crisis had degenerated into a full-blown economic crisis and was creating uncertainty for every company.

If we now turn our attention to the present, valuations for the companies I own are currently at PER of 2-3x (historical), which would seem to represent "trough" valuations for a worst-case scenario situation for all companies concerned as to the opaqueness of future earnings and growth. Of course, one can also argue that the extent of the drop in valuation metrics is largely due to a depression-type scenario being factored into the prospects of all companies' growth plans and hence "disrupting" the original good intentions of the companies to grow as previously forecast. Hence, the original estimates which pertained to perceived growth rates for the companies concerned have to be abolished (in the worst case), or modified drastically (in the most optimistic case).

The point I wish to make here is that I've learnt (after going through this bear market which we are still in right now) that the uncertain future always means that an investor should accept a significant discount to perceived "superior" growth if one should consider purchasing shares in a company. This is of course linked to the concept of "Margin Of Safety" in that I have to modify my method of assessing what I deem as a reasonable margin of safety. During bull markets, when growth is clear, Mr. Market is happy to assign high valuations to companies that, on hindsight, apparently were too high for comfort. During bear markets, recessions and economic crises, Mr. Market will take a very dim view of the prospects of a company and thus assign a very low valuation for companies.

So the question to learn is not to be overly confident of a company's growth plans and overpay for its shares, even though things appear to be mapped out way in advance and nothing can be seen on the horizon to derail the company's plans. I've learnt the hard way that growth is never certain and one should always be prepared for nasty surprises, thus having a greater margin of safety is more important than ever. The bottom line is that one should always purchase as if one is expecting a bear market and economic crisis to hit, and accept valuations which are very low compared to the prospects of growth. The problem, of course, is that during bull markets such valuations are almost impossible to find, thus making purchase a problem. Which is why people say that the best time to purchase is during a bear market even though growth may be highly uncertain, as we should then turn our attention to qualitative factors (e.g. Management's track record through previous recessions) to justify purchasing a company.