Sunday, April 26, 2009

Confessions of an S-Share CEO

Recently, it came to my attention that an anonymous letter had been penned and circulated to various parties regarding “confessions” made by a (supposed) CEO of a Singapore-listed S-Share company. This letter was supposed to be written to let the whole world know about the shady insider dealings in relation to the IPOs of China Companies listed on the Singapore Bourse, as well as to reveal the inner machinations which went on “behind the scenes” which enabled many parties to get rich; but which ultimately left the retail investor “holding the baby”.

While the authenticity of such a “confession” can be debated, what was written (yes, I do have the full copy of the text but it would be too lengthy to post it here, so please follow this link ) constitutes a peek into the shady and dubious world of deal-making, private equity and the eventual listing. Even Ms. Teh Hooi Ling of the Business Times wrote an article on this in yesterday’s Business Times commenting on various aspects of such deals and how these companies can be hyped up, marketed and eventually sold to the public. It is not unlike the heydays of the IPO boom which led many new companies to aggressively sell their shares to unwary investors, all with the promise of growing revenues and soaring profits. I would like to use this article to illustrate some aspects of IPOs and deal-making which I feel can be learnt and which are significant to retail investors like myself.

It was mentioned in the article that if you pumped enough money into a company, it could look very much more “alive” than it really is. This was alluding to the fact that if one wished to “promote” a company, all one needed to do was to find some private equity investors (“angel” investors), put money in, aggressively spend on capex and new products; then push them to customers all on credit, all the while booking in the revenues but not collecting the cash. Such an accounting “trick” is widespread in commodity businesses (the letter stated that it was a “chemical fibre” business in the textile industry, which led some to speculate that it may be the recently suspended Fibrechem). Barriers to entry are low and as margins are thin, so introducing new products and investing in technology is risky especially if customers are not willing to take up the new products. Hence, the deal-maker (Mr. D in the article) is the one responsible for making a mountain out of a molehill (figuratively speaking) and transforming the company to something much bigger than it actually was. In other words, mediocrity was perceived as quality based on a change in appearances.

The article also highlights the fact that in most IPOs, the ones who benefited the most are the original people who pumped money into the company at very low valuations (perhaps 1-2X PER), and which later filed an application to list under bullish conditions, thereby garnering gains of 5 to 20 times of their initial investment. Since companies could be “dressed up” to look very nice, the numbers may not be heavily scrutinized by the general public prior to IPO, and anyway everyone knows that IPOs are hot during bull markets as everyone wishes to “stag” it on its first trading day. This is probably one reason why IPO stands for “It’s Probably Over-priced” ! Companies will choose to sell their shares during periods when their shares can command the highest valuations, as this means they can raise the maximum amount of money possible, even if they don’t need it ! IPOs are sometimes also mechanisms for the existing owners to cash out and get filthy rich in a short period of time.

Investors who buy into such growth stories have to be wary of the people pushing the IPOs, as the article clearly states that everyone in the IPO-cycle benefits in some way from the listing – except the retail investor. A very noteworthy paragraph which I will reproduce here states as such:

“Everyone got what they wanted. The Chinese companies got their money to expand their business (which at a later stage, no one is really sure which company really had any business to start with), the entrepreneurs were handsomely rewarded for the risks they undertook, the deal makers got their fees, the angels made their killings, the bankers collected their fees and dished out new loans, the lawyers and accountants recruited more young graduates to cope with the record work volume, the stock exchange got their “new mandate as the second board of the Chinese companies”, the investors got their hot-and-sizzling China concept stocks and above all, the rich and the influential members of the “invisible clubs” were all happily enriching their own pockets”.

I think the above is self-explanatory and only serves to reinforce the fact that everyone has a part to play to push through an IPO as there is a lot of money to be made even before a company gets listed. Investors have to spend time separating the wheat from the chaff and this is admittedly not easy; but one easy thing to note is that the quality of IPO companies drops as the bull market gets hotter and hotter, and valuations get more and more crazy.

One final point I wish to highlight is that the bubble eventually HAS to burst, just as it did for the companies in 2000. The immense hype, easy money and over-leveraging were the perfect storm for a crash and the subsequent bust. Even in 2006 and 2007, when S-Shares were touted as the next big thing, there was already an element of “bubbling” as the China growth story was pushed and touted again and again by a myriad of analysts. Everyone wanted the party to last and indeed, everyone acted like Cinderella dancing in a room without clocks. When midnight struck, everything was reduced to pumpkins and mice. This is a lesson for me and other investors too – beware of hype and slick marketing; don’t leave your brains at the door when evaluating companies. It takes a very clear, sharp, objective, rational and analytical mind to see through the thick coat of gloss which covers the true prospects and financial situations of many a company.

Thursday, April 23, 2009

Ezra – 1H FY 2009 Analysis and Review Part 2

Part 2 of my analysis focuses more on the Group’s prospects, plans and strategies and how these can sustain the business in the years to come. My investing style is such that analysis of numbers and ratios only forms one part of a holistic review of the business, as I believe numbers alone do not tell the whole story about a Company and thus cannot solely be relied upon for margin of safety with respect to a potential investment. Rather, a company is the sum of its quantitative and qualitative aspects, hence one should analyze these aspects to the best of his ability in order to come up with a reasonable conclusion as to the merits and demerits of an investment.

Fleet Expansion Plans and Updates

Total current fleet capacity for Ezra is 246,600 bhp (brake-horsepower). The aim is for the Group to reach a total bhp of 318,600 by FY 2010, representing an increase of 29.2%. The good news is that in Part 1, I mentioned that the capex requirements for 2 MFSV from Karmsund have been eased. Thus, this would indicate better gearing and hopefully more healthy cash inflows in future periods. 2 MFSV and 2 liftboats are scheduled to enter Ezra’s fleet by FY 2010, and for FY 2011, there is one more planned MFSV (this should refer to the Keppel Singmarine MSFV which is currently under review). No formal announcement has yet been made on Ezra’s part about the proposed cancellation of this MFSV, though it was reported by Keppel Corp that Lewek Shipping (a subsidiary of Ezra) was negotiating the cancellation of the contract, forfeiting the deposit paid.

The capex requirement for the vessels is US$275 million, which should be obtained from the drawdown of more bank lines and bills payable. From prior announcements, Ezra has already obtained the necessary funding and can draw down on these credit lines when required. Ezra’s relationship with their bankers remain healthy as their vessels are pegged to long-term charters, thus cash flow visibility is strong; giving the banks no incentive to “pull the rug” from under them. With Lewek Arunothai set to begin gas production in 3Q 2009, this should also reduce EOC’s high gearing.

Another US$75 million has been earmarked for their Vietnam Yard expansion and Energy Services Department. I suspect this is for their new yard in Vung Tau whereby the land has already been obtained but for which construction has yet to commence. Their current yard in Ho Chi Minh (District 2) had already clinched 3 contracts with a total orderbook of US$214 million, of which 68% (about US$145.5 million) is still outstanding and should be spread out between FY 2009 and FY 2010. With a gross margin of 20%, this should translate into gross profit of US$29 million spread out over the two years. The Group is also focusing on improving their suite of products for Energy Services and to integrate this into their offering so as to improve margins and snare larger customer contracts. Currently, Energy Services division is the up and coming new division of Ezra but the gross margins are noticeably poorer at 13% compared to 40% for Offshore and 20% for Marine.

Territorial Expansion Plans and Oil Demand

Ezra currently is targeting territories such as South America, Africa, North Sea and China as potential areas of expansion even amid this severe crisis and recession. Though the Energy Agency has forecast the lowest energy demand in 5 years as a result of the global downturn, oil majors remain committed to pump in capex for oil and gas E&P activities as an under-investment may mean trouble once the economy recovers and demand surges. I am a believer that oil prices will continue to trend upwards once the recession eases due to the lack of significant capex being ploughed into E&P, as a few major projects have been derailed due to lack of financing. According to the presentation slides, oil majors such as Petrobras are going to invest in E&P until 2013, while Africa holds the majority of global deepwater O&G reserves. These have yet to be tapped and represent good potential areas where Ezra can offer their services as their fleet is tipped to be 83% deepwater-capable. I view this as a potential strong earnings contributor in future as shallow water reserves dry up and oil majors need to drill deeper in order to extract. Also, I do not believe oil is going to run out within 50 years, thus the Group can still continue to do well in the medium-term due to this consistent demand.

Prospect – EOC’s Second FPSO Contract

EOC is bidding for another FPSO contract in Vietnam and it has been reported that they are the surprising front-runners for this contract. Unfortunately, there has been no progress made on this thus far as EOC has been unable to obtain appropriate financing for this huge project (the capital outlay for such an FPSO is very large). Hence, this project is under negotiation still at the moment as both parties hammer out the technical details of the FPSO. If EOC manages to clinch this contract, it would significantly boost earnings and cash flows, but on the flip side it will also increase gearing in the near-term.

Prospect – Recurring Charter Contracts

Ezra recently reported clinching US$47 million worth of new and renewal contracts for their vessels, which shows strong demand for these vessels. Previously, some comments on Ezra had highlighted the dangers of vessels laying idle as running costs are significant and depreciation on these vessels can be very high. Some of the vessels are also on operating leases through sale and leaseback arrangements and thus have to make payments to their lessors regardless of whether the vessels are being deployed on contracts. Hence, it is imperative that the Group snare back to back contracts as far as possible (except for mandatory dry-docking) so that their assets are put to productive use. Any idle time would represent a significant drag on cash flows and earnings, and this is an inherent risk in their business model. But with the O&G segment remaining buoyant even during this difficult time, I am confident the Group can continue to achieve high vessel utilization rates.

Final Dividend for FY 2009 ?

Due to the massive capex and funding required for its new deep-water capable vessels, it is no surprise that the Group has not declared either a final dividend for FY 2008 or an interim dividend for 1H FY 2009. The last dividend declared was a special dividend of 5 cents per share (post-split) for 1H FY 2008, for which I had received. That was due to the sale and subsequent listing of 51.1% of EOC on Oslo Bourse, thus flooding the Group with cash.

Looking at the state of their cash flow statement for the past few quarters, Management has to remain prudent in their gearing and not over-leverage for fear of incurring high interest charges and crimping their cash flows. The increase in receivable collection days from 100 to 130 days is also a sign of poor receivables management, which is surprising considering about 80% of their customers are oil majors or national oil companies.

All I can conclude is that the Group had better buck up in terms of improving its collection cycle, and also to demand payment faster from customers for work done. Notwithstanding the financial crisis, Ezra should tighten its credit policy and not let its collection cycle deteriorate further.

Because of the factors stated above, I will not be expecting any final dividend from the Group for FY 2009 when they report their results in October 2009; unless they show a significantly improved cash position for 3Q 2009. Even so, it may be better for Management to hoard more cash during tough times and only start paying dividends once things improve.

Sunday, April 19, 2009

Paying a High Price for a Cheery Consensus

Yes, those of you who saw the title are probably thinking it looks very familiar ! It was actually a quote from Warren Buffett when he mentioned that you “pay a very high price in the stock market for a cheery consensus”. I must admit yours truly was quite stumped when I first came across this statement and was wondering what it meant and what implications it had. Initially, I thought he was referring to paying high prices for shares of companies and thereby agreeing with what everyone thought about the company – a form of herd behaviour. Later I realized I was quite wrong when I was thinking about the stock market and the full meaning of this statement hit me like a bolt of lightning from above.

In the context of this bear market, we can be considered to be experiencing one of the worst bear markets and recessions in at least the last 70 years. In fact, economists and market experts have termed this period as “The Great Recession” as many aspects mirror the Great Depression era of the 1930’s, with the exception of more globalization now, more co-ordinated stimulus efforts and more liquidity being pumped into each economy by respective central banks. Most investors have seen their portfolios literally melting like hot candle wax since October 2007 to the troughs seen in October 2008 and more recently, March 2009. Economists and government officials have gone on record stating that the recession does not seem to be lifting any time soon and there is a lack of clarity and visibility on how things will turn out. In Singapore, the MAS revised their GDP forecasts for Singapore for FY 2009 to a range of -6% to -9% (from -2% to -5% just a few months back). Exports are falling off a cliff and year-on-year GDP growth rate for 1Q 2009 has slumped 19% to make it the worst quarter since Singapore became independent.

So what does all this news portend for the retail investor ? Well, for starters, Mr. Market has become very pessimistic and is willing to pay very low prices for most companies, be they good or bad. This is where the phrase comes in – we tend to pay high “prices” (i.e. valuations) for a cheery consensus (clarity and certainty). The words in brackets help to explain the sentence in the context of how it should be viewed. Valuations are low when there is a lack of clarity, companies are reported declining profits and analysts are scrambling to value companies based on Price-to-book, rather than Price-to-Earnings. This is because earnings have become so uncertain that a different metric must be used, they argue. Price to book is “safer” in that it assumes a more conservative stance with respect to a company’s book value, which is usually the liquidation value of a company after accounting for its assets and liabilities; rather than volatile earnings which can fluctuate from period to period due to the severe slump in consumption and lack of financing options for growing the business.

Hence, an investor cannot have the best of both worlds. I repeat, it is impossible to have the cake and eat it too ! What I mean is that one cannot have clarity and certainty on a Company’s future growth and earnings, yet expect to pay a low price for it. A “cheery consensus” means that everyone is happy and satisfied with a company’s future, and thus when this happens, we inevitably end up paying a very high “price” for it, meaning margin of safety would be lesser; as compared to when the future is cloudy and murky and uncertainty reigns.

The lessons one should take away from this is that uncertainty is the friend of the buyer of long-term values, after assessing the corporate strategies and financial fundamentals of the company in question of course. Uncertainty is the only guarantee in the stock markets and as investors, we deal with uncertainty ALL THE TIME. Every earnings report is uncertain, as is the ability of a company to continue to pay dividends and grow earnings. What investors need to realize is that instead of avoiding uncertainty, we have to manage it actively and learn to live with it. We have to learn to pay low prices for a certain tolerable level of uncertainty, and to be able to bravely invest even when the future is highly uncertain (as it is as of this writing).

How can one mitigate against the risks of being wrong about uncertainty and buying a dud company ? I for one use qualitative metrics such as Management experience, how they navigated previous downturns, their track record over 5-6 years in growing the business, their conservatism (or aggressiveness) as well as how they allocate capital. To give some pertinent examples, I will use Tat Hong and Swiber to illustrate.

Swiber recently bought back some of the company’s shares at a price above S$1.00 when it could have used the cash to fund its capex program. Now it is fervently selling off OBT and also part-ownership of its vessels (Swiber Victorious and Swiber Chai) to raise more funds as the downturn intensifies. This is what I call a “horse behind cannon” move as Management should have anticipated the global credit crunch more astutely and begun to conserve cash instead of using it on share repurchases at much higher prices than the current market price. To me, this is a classic case of poor allocation of capital on the part of Management and also an inability to properly manage a crisis, reflecting inexperience. This is not surprising since Swiber is only a 13-year old company established in 1996, and was only recently listed in 2006.

Tat Hong, by contrast, has shown much resilience in its business model as it switches from an equipment sales company to a rental company. Management has about 30 years of experience in this industry and have been through crises such as the Asian Financial Crisis and the Dot.Com bust. Through such crises and economic downturns, they have learnt how to conserve cash and protect profits from eroding quickly. The experience from past recessions has served them in navigating the current rough seas, and even though they are not totally unscathed, at least I view them as being more astute in Management capital than Swiber.

So the key to investing successfully is to observe Management’s quality and to avoid paying too high a price for a “cheery consensus”. Learn to expect uncertainty and to invest because of it, as that is the only way one can lock in low valuations and achieve one’s desired margin of safety.

Wednesday, April 15, 2009

Ezra – 1H FY 2009 Analysis and Review Part 1

Ezra released their 1H FY 2009 results on April 8, 2009. Below is an analysis of their results as well as a discussion of their prospects. Since this analysis is long (for a reason to be explained in a later section), I shall split it into two parts. Part 1 shall deal with the numbers-heavy portion which includes the Profit and Loss Statement, Balance Sheet and Cash Flow Statement (supported by attached spreadsheets). Part 2 talks more on the qualitative aspects for Ezra, prospects and catalysts for growth in the near future and also comments on other aspects of the Company which I feel are worth mentioning. Be sure to check back in due course for Part 2 of the analysis.

Profit and Loss Analysis

As can be seen from the table above, Ezra’s sales mix has seen quite a change from 1H FY 2008 as it has added a new Energy Services Division. This has contributed US$46.1 million in sales for 1H FY 2009, providing a strong boost to total revenues which have increased 87% year-on-year. However, due to the change in sales mix with more revenues skewed towards Energy Services for 1H FY 2009 (26% compared to 1H FY 2008 4%), as well as the indicative gross margins of just 13% for Energy Services Division, this has dragged down the entire gross margin for the Group from 38% in 1H FY 2008 to just 29% for 1H FY 2009. Moving forward, the Group is prepared to offer an integrated services model to buoy profits by offering a one-stop solution service for customers, thereby hopefully improving on gross margins across all its divisions.

Financial expenses (i.e. interest expenses) increased 71% for 2Q 2009 compared to 2Q 2008 due to the increase in drawdown of bank loans and bills payable in order to fund capital expenditure for fixed assets. Though no vessel was reported to be delivered in 2Q 2009 (the last reported delivery was Lewek Plover in 1Q 2009, specifically November 2008), I believe that the Group needs to draw down on their credit facilities in order to pay equipment suppliers and the vessel builders on progressive payments. These fixed assets are then recognized on a progressive basis through capitalization in the Balance Sheet. Administrative Expenses as a percentage of sales dropped from 28.5% for FY 2008 to 8.5% for 1H FY 2009, mainly due to the absence of a one-off provision for staff made in FY 2008.

Net profit for 2Q 2009 increased a respectable 21% due to the inclusion of the new vessel Lewek Plover, and this is before accounting for the earnings which will be accrued from the start of gas production from Lewek Arunothai which belongs to EOC. Earnings are expected to flow through share of profits of associated company once this happens, and boost this figure further. Net margin for 2Q 2009 was 23.7% compared to 25.5% for 2Q 2008, mainly due to the change in sales mix and the higher financial expenses. If the exceptional gain from EOC is stripped out of 1H FY 2008 results, the recurrent PATMI is US$15.0 million, which means there was a 61% increase in PATMI from 1H FY 2008 to 1H FY 2009.

Balance Sheet Analysis

The one point I would like to highlight immediately in the Balance Sheet is the increase in trade receivables of US$45 million, which is a worrying sign. Ezra’s cash conversion cycle has also increased from 100 days to 130 days, while their current ratio has fallen from 1.5 as at FY 2008 to 1.1 as at 1H FY 2009. All these point to the fact that collections are getting slower from customers and that receivables are building up instead of being converted to valuable cash – an unhealthy sign at any time but more so during this severe recession. The drop in current ratio is attributable to the drop in cash and cash equivalents while bills payable (a short-term liability) increased significantly. Fixed assets also increased by 59% to US$290.2K as a result of the delivery of more vessels, as well as the capitalization of construction costs for vessels.

The above table illustrates the debt profile for Ezra and shows a disturbing trend of increased short and long-term loans, and reflects that total bank loans had increased by 33% in order to finance the newbuilds. According to Ezra, net debt to equity increased from 11.4% as at FY 2008 to 47.1% as at 1H FY 2009, which is disappointing as it shows that they had not managed to generate more cash than they are borrowing. More will be discussed on this under Cash Flow Statement Analysis.

According to the debt breakdown, bills payable was the most common method used to finance purchase of fixed assets, increasing 255% over the period being compared. Long-term loans were also drawn down while short-term bank loans decreased probably due to some pay offs. A comment left by an investor Donmihaihai has questioned me about the increase in fixed assets as well as bills payable and the fact that the numbers do not tie. The table shows an illustration as well as a journal entry on why this could be so. The “missing” US$49.5 million worth of increase in fixed assets which were not explained by the cash outflow could be due to a direct journal entry by debiting Fixed Assets (Vessels and Equipment for example), with the corresponding credit going to Bills Payable directly. This is a perfectly legitimate accounting entry where cash does NOT flow to the Group but is instead remitted directly from the bank to the supplier through an instruction or standing order.

Of course, one can argue that about US$12 million worth of bills payable is still “unaccounted” for after I passed the journal entry. What I am trying to say (and show) is that a Company can employ a variety of methods to properly account for their assets and liabilities with no cash effect, thus it would not be possible to trace every single number in the financials unless you knew the exact transactions involved and also could take a look at Notes To The Accounts (which are not prepared for unaudited financials). Most of the time, no attempt is made by myself to rigorously tie all the numbers back to the financials, unless of course there was suspicion of possible fraud (which would then entail calling in CAD and the forensic auditors). Furthermore, fixed asset additions may also be made from assets under construction or re-classified from assets held for sale, and not necessarily through direct cash injections. Without knowing the exact journal entries involved in the consolidation, it would not be possible to tell. I hope this answers that particular comment which was left on my blog even before I undertook this analysis.

The table above shows that the net debt to equity increased quite significantly at first glance, but a quick check on total debt to equity shows that the increase was not so severe after all. Because of the high cash position and lower debt level as at FY 2008, the net debt was much lower and thus the net debt/equity ratio was just 14.4% (it is 11.4% as stated in Ezra’s presentation slides). Bank loan movement would imply that there was a net cash inflow of US$1.5 million, but it was shown in the cash flow statement as a net outflow of US$3.3 million for repayment of bank loans. The problem here is that the company shows the figure as a net figure of bank loans raised and repaid; thus I will be requesting the Company to disclose these 2 numbers separately in future for easy computation.

Cash Flow Statement Analysis

If there was quite a bit of mention of cash in the previous section, my apologies as there is a significant overlap when it comes to comparing Balance Sheet balances and cash flows. This is due to the indirect method of cash flow statement preparation which takes into account movements in working capital as well as movements in balances as stated in the Balance Sheet.

Ezra disappointed by showing a net cash inflow of only US$259K for 6 months ended Feb 28, 2009 as compared to a much healthier inflow of US$6.9 million for 6 months ended Feb 29, 2008. Much of this can be attributed to the US$45 million increase in trade receivables, as well as a lower amount due from associated company as well as higher interest and taxes paid. The key to resolving this issue would be quicker collections from their customers, most of whom are oil majors and national oil companies, in order to alleviate the cash flow crunch and improve their operating cash inflows.

As for investing cash flows, most of this was dominated by cash outflows for purchase of fixed assets and assets held for sale. US$9.45 million was spent on purchase of other investment, which are unquoted preference shares with a dividend yield. Since this investment has a dividend yield and consists of preference shares, it is positive as it means more future secured cash inflows. These outflows were offset by the proceeds of disposal of assets held for sale as well as dividend from joint venture company. Note that although share of profits from joint venture company Casadilla dropped drastically for 1H FY 2009 due to the loss of Liftboat Titan 1, there was a refund of monies relating to this loss through insurance payout and we should see this inflow being reflected in 3Q 2009. Note too that the deposits of NOK 184 million paid to Karmsund have been refunded in 3Q 2009, so this should significantly improve cash flows even though it is a one-off item. Don’t forget that capex pressures are also eased as a result of the cancellation of the 2 MFSVs which were supposed to be constructed by Karmsund before they went bankrupt.

As for financing cash flows, as explained earlier, proceeds from bills payable was offset by repayment of bank loans. The table shows that total debt actually increased by about US$64.3 million but this is hardly even reflected in the cash flow statement which shows a net cash inflow of US$961K. A possible explanation put forward might be that the loans drawn down are immediately used to pay for equipment and assets, thereby there was no cash effect at all which can be reflected in the Cash Flow Statement. Readers are free to suggest other possible reasons for this “discrepancy”.

The result of all this is a net cash outflow of US$57.5 million. Coupled with exchange losses on fixed deposits denominated in NOK and GBP, the total cash outflow effect is about US$70 million. Unless Ezra improves on their cash management by 2H FY 2009, otherwise I would say this is a very disturbing trend and does not make me feel very comfortable as a shareholder, even though their recent capex reduction plans have put me more at ease.

No dividend was declared for 1H FY 2009 and looking at the state of the Balance Sheet and Cash Flow Statement, it is no wonder that they cannot afford to pay out any cash. It would not be too far-fetched to say that unless their cash inflows improve significantly in 2H FY 2009, there would probably be no final dividend as well (similar to the situation for 2H FY 2008 where no final dividend was declared). Such is the price to pay for investing in companies which require high capex, and in future analyses of companies to invest in I will take this into account.

Please stay tuned for Part 2 of the analysis, which should be ready in about a week’s time.

Friday, April 10, 2009

Personal Finance Part 12 - Indebtedness

In this next article on personal finance, I would like to touch on the subject of debt. No doubt the news has been going on about credit card balances being rolled more often, amounts getting larger as well as people purchasing flats which are (to me) getting more expensive. The latest HDB flats which are part of the DBSS Scheme cost a cool S$720,000 for a 5-room larger unit, which is even more than the price of some mass-market condos. Yet there are people taking up these (over-priced) units. The TODAY newspaper also recently reported a jump in the number of luxury sports cars and marquees being purchased, as if Singapore was not going through its worst recession in 70 years. So what's up and can this seemingly strange phenomenon be analyzed ?

Perhaps I can start off by commenting on the general mentality of the youth I encounter these days. "Youth" in this case represents the Generation "Y", who are in their early to late 20's to early 30's. These youths have not been through the struggles which our ancestors have been through and have been living a life of economic prosperity and relative abundance compared with most of our peers in other South-East Asian countries like Indonesia and Vietnam. Some would say that this has made them spoilt and pampered and their thinking has also evolved to reflect this. Youth nowadays think nothing of splurging on fine dining, a new mobile phone or the latest gadget, all in the name of keeping up with the Joneses. In addition, most of them also have no qualms about taking up loans to finance huge purchases like cars and property, as they feel that they can sustain a steady cash inflow through their career and/or passive income which can help pay for their lifestyle. This view is inherently flawed and risky as the future is always uncertain and one should maintain a "margin of safety" (i.e. buffer) when taking up such long-term liabilities.

On to the subject of properties, there have been lots of news articles and advertisements recently in the Straits Times, Business Times and TODAY newspapers featuring mass-market condominiums and the new condo-like HDB flats. These are generally priced around $500K to $700K and the difference is that for condos, there is no salary limit while for the condo-like HDB flats there is a salary cap of S$8K combined for the married couple. Many of my peers have chosen "quality of life" by buying condominiums worth about $600K to $700K (one even bought one exceeding a million SGD !) and taking up loans as long as 30-35 years. For some, this means that they would be indebted to the bank for most of their adult life (and probably part of their retirement years as well), while for others who can afford to put down a larger downpayment, their loan tenure may be shorter but they will be more severely starved of cash once they had made the down-payment.

If you think about it logically, one is paying for a premium space in the sky as well as amenities which come at a high price. Condo living is considered something most people yearn for as a status symbol and I would argue that most would treat upgrading from HDB to condos as a sign that they have entered a new strata of social status. It's also one of the original 5 "C"s which continue to dominate the mentality of Singaporeans - Car, Cash, Condo, Credit (Card) and Country Club. Of these 5, car and condo are still considered prestigious and command a certain level of respect, even though it may set you back by thousands of dollars and put you in debt for most of your life. When friends of mine tell me they took up a big loan (e.g. $500K and above) and are paying for 30-35 years (sometimes even using cash in addition to CPF as CPF OA contribution is capped at S$4,500 gross salary), the first thing I ask is whether they had prepared for contingencies and whether they plan to be able to save any money. Having things as they are now are fine until you consider the fact that children may come next, as well as probably a domestic helper too. These increase the financial burden significantly and within 30 years, if one assumes 3 recessions in total (1 every 10 years), then there is a significant chance of either losing your job or getting a pay cut throughout this period. Putting this in context, it simply means that one should NOT over-leverage based on today's conditions as tomorrow may be very different indeed. A mortgage loan is not something one can shed off easily and one may end up being a financial prisoner to the bank or HDB without recourse. For me, I choose to live in an HDB 4-room flat and have a remaining HDB loan of about 8 years remaining (cut down from an original length of 21 years through consistent increments in installment payments in addition to partial loan redemptions, all through CPF). My aim is to be able to reduce the remaining tenure to about 5 years so that I can finish paying off the loan before I hit 40 years of age.

Another aspect to discuss are cars. Somehow, I can never understand why Singapore is one of the most expensive countries to buy a car. A brand new car (including COE) can set one back by about S$70K to S$80K, and higher-end models like BMWs and Mercedes S-Class can set one back by $150K to $250K. It's no joke because some cars cost as much as a 3-room HDB flat, and remember you can't live in your car and it doesn't have an attached bathroom ! Generation "Y" seem to be more obsessed with cars as I see many young people fresh out of University buying a car with zero downpayment using their first few pay packets. The banks have not helped either by extending the previous maximum 7-year loan to the present 10-year loan system, and with no downpayment required, one can chalk up quite a huge debt just to drive away with a fresh set of wheels ! I am always of the impression that behind every set of beautiful wheels is an equally beautiful loan. The TODAY article on the increase in sports car purchases is believable, as nowadays I can spot one sports car (2-door variety) almost once every five minutes as I sit in an SBS Bus. The driver usually looks very young and these days the incidence of young female drivers behind the wheels of such "cool cars" is increasing. Car loans are NOT amortizing loans are the interest is computed on a flat basis at the start of the loan tenure and divided by the loan period, so there is no help in paying off a large sum during the loan tenure as it does NOT reduce the remaining liability. In addition, cars are assets which depreciate extremely quickly and a second hand car about 3 years old may not even give you 50% of its original purchase price, even though the COE can last for 10 years. This is why I think cars are a bad proposition when it comes to building wealth, as they tend to drain a lot of financial resources and can be considered more of a liability than an asset (if you discount the "convenience" factor).

It's not unusual for people to own cars these days, especially when couples start having children and maids and need to ferry them around to their parent's place or the nearest child-care centre. Most married couples I know own cars, and many single young guys and girls also own cars, though I am quite confident most of the younger ones don't earn a salary exceeding S$3.5K a month. The thought of a car did cross my mind, until I considered how indebted I would be to the bank, and the fact that about S$1,200 a month would be spent on car-related expenses like petrol, ERP, parking, insurance and road taxes (including the installment). So for now, I am very happy to continue taking public transport like SBS Buses, MRT and the occasional cab.

So to summarize, I have discussed some aspects of indebtedness and my stand is that I avoid excessive debts when I am young so that I can enjoy a better chance of retirement when I am older. By controlling our WANTS and differentiating them from our NEEDS, we can endeavour to save more and ensure we do not build up long-term liabilities which will be hard to shake off when we approach our retirement years. One should also note that CPF OA contributions decrease with age and the chances of one finding another job are lower the older one gets. Hence, one should pay down more of their housing loan at the start of their productive working life rather than at the tail end of it.

Would any readers care to share comments and views on being indebted ? Do you think this is good or bad and what are your experiences to share in terms of owning cars and condos and other lifestyle products ? Do you think this consumerist culture should be encouraged or discouraged ? Feel free to comment, thanks !

Saturday, April 04, 2009

The Problem with "Bear Market Rallies"

Of late, Mr. Market has seemingly begun to look a little more on the sunny side, instead of remaining moody and depressed which was his prevailing mood for the past 17 months. Just to remind, the Singapore Stock Market's index (STI) has risen in 4 straight weeks, with only 5 "down" days out of a total of 20 trading days (meaning 25% down, 75% up). Many may recall that it was only on March 6, 2009 when the Index hit a 5.5 year-low (of 1,456.95), after which it has so far rallied around 25% to its current level of 1,820.87. The sharp rebound has had many pundits and investors shaking their heads and rolling their eyes, and provided no end of amusement to the author of this blog (yours truly). I will proceed to explain why below, so dear readers, please be patient and read on.....

Interestingly, most analysts and economists who were interviewed were decidedly bearish and pessimistic. They pointed out (rightly so) that the economy had yet to bottom, manufacturing data was still weak, exports had fallen off a cliff and unemployment (in the USA and Singapore) was set to increase even further. Against such a bleak backdrop, how could rallies possibly sustain and how could Mr. Market be perceived as being more sunny and optimistic for an extended period of time ? The even more cynical ones point out that corporate results reporting season is due in a few weeks' time, and the probability of more companies reporting dismal earnings and lower profits would cause "reality" to sink in and give Mr. Market a blow in the face for being too exuberant. In short, there's nothing much to look forward to given that data, numbers, facts, figures and sentiment are so poor right now. Even if there was some hope that things were "bottoming out", these experts are quick to point out that more certainty needs to come along in the form of hard data to justify any cheer that the gloom is about to lift.

The above paragraph shows the distinct difficulty in what investors would term the "tricks" of Mr. Market. To quote a very over-used cliched line: "Bull Markets climb a wall of worry". This basically means that a bull market has to overcome an amazing load of negative news, all the while reaching for greater heights and overcoming adversity (and doubt). The greatest difficulty faced by pundits and seasoned experts who observe markets is in differentiating between a bear market rally (of which many occurred during The Great Depression) and the start of a genuine bull market (or even if not, at least an end to the current bear market). Understandably, the confusion often lies in the fact that no one can predict future turn of events well enough to state if economies will recover, and how soon that will be, and to what extent. Investors are also unaware if markets have priced in the most pessimistic scenario in terms of earnings growth and industry doldrums, and thus prices only have one direction to go in future which is: higher. This confusion and lack of clarity is the main reason which keeps investors from placing their money in good, high quality companies for fear that "the bottom has not been reached".

In order to adopt good value investing practices, one must identify suitable value and purchase at a price which provides a decent margin of safety. In the case of Mr. Market's moods, I have often used the STI as a rough barometer of sentiment, and thus have made my purchases on days when the Mr. Market is pessimistic, rather than when he is exuberant. The fear that "the bottom" is still out there does not make sense to me because I believe it is impossible to time the market - thus an investor should just look out for good value and purchase within his means. If we have evaluated a good company and understand its business characteristics and are confident with its prospects, we should feel comfortable buying at current depressed valuations. Too many people live with the perpetual fear that Mr Market's moods will determine if their investments will do well or badly, but then one must remember that it is his pocketbook which we have to take advantage of, and we must NOT be lulled by his schizoprehnic mood swings.

As long as one purchases with a value mindset, one does not have to care if a rally is a "bear market rally" or a "genuine rally". That is the focus and discussion for analysts, pundits and prognosticators who make a living out of predicting and commenting. They are fun to read and amusing to follow but offer no real value in terms of building wealth through the ownership of equities, as most of them are armed with a trading mindset to boot (e.g. sell into the next bear rally after prices have risen 10% etc). With the fricitonal costs relating to frequent trading, volatile market mood swings and the risk of getting whipsawed often by changing sentiments, I find it hard to see how most traders can consistently make money.

In adhering to my value investing principles, I have, of late, also learnt more about the way businesses and companies function during long periods of drought where financing dries up, as well as how companies cope with adversity (e.g. slashing selling prices, cutting costs aggressively by retrenching). It has been a good learning experience and I now understand businesses better than before and it will assist me in my evaluation of more companies to own in future. I am glad that I have managed to escape a severe permanent loss in capital through the concepts of value and margin of safety - it could have been a lot worse had I been speculating recklessly or if I had purchased "over-hyped" companies with flawed business models.

Note: Ezra Holdings Limited is expected to release its 1H FY 2009 results on April 6, 2009. I will do a review shortly after I have digested the numbers and facts.