A Long Hiatus......

And so, I am back. Blogging again once more after an absence of 6.5 years, but it feels good to be able to express myself through writing once more. Much has happened in the intervening time - I obviously got much older (I am in my 40s now, and in danger of suffering from the dreaded "mid-life crisis" which everyone talks about), fatter (a consequence, no doubt of being married and corpulent) and hopefully, much wiser. At least the years have been kind enough to leave me with most of my hair, seeing many of my compatriots and peers with balding pates is enough to make me thank my lucky stars!

So what happened to me during the six and a half years? In a nutshell, I was recruited into the investment industry (yes, the day of my very last post was the day I started work) and was not allowed to blog due to conflict of interest, and also because of MAS requirements. While in the industry, I enhanced my knowledge significantly through on the job learning, training with financial modelling and meeting more companies than I could ever imagine. The experience has been humbling, to say the least, as I also encountered scores of very sharp and smart investors along the way. Networking events and many a cocktail have exposed me to the myriad ways in which one can invest, across all asset classes, and with many different strategies (some obviously worked better than others!).

My aim in joining the investment industry was to build up my knowledge to become a much better investor (OK, part of the reason was also because the money was more attractive than my previous role, but not a whole lot more). In the process, I found that even trained investment professionals suffer from the same biases and mental shortcuts which afflict retail investors; and that relationships matter more than performance alone when it comes to dealing with high net-worth clients. I also found out just how competitive the investment landscape was - everyone and anyone would start a Fund, attract around USD 10 million and then start marketing aggressively. I must have met at least more than a hundred Funds (some with very colourful names, no doubt) in my course of work, and also learnt from numerous fund managers and IR personnel on how they size positions, analyze companies and businesses, observe management, manage their cash positions (to avoid cash drag) and turn over their portfolio.

The really good funds are few and far between, and have a track record of >10 years (dating past the GFC) and returning low teens % every year, on average. Most Funds are new and the managers are excited to shout out their performance to the world, but these will tend to fall flat on their face amidst a crisis or fizzle out and under-perform their benchmark after a while. After a while, I learnt that those which stuck to a good, consistent and rigorous process tended to do well over time, and beat those with arcane strategies as well as those with more bluster than substance.

But even though much has changed, a lot has also stayed the same. I am still living in the same HDB flat (no "upgrade" to a condo), still do not own a car (yes, I still commute using BMW "C Series - Bus, MRT, Walk and Cycle) and my family still generally frequents the same cafes and restaurants over the years. My daughter is older now and attending a primary school instead of kindergarten but essentially our lives have stayed fairly constant - just the way I like it.

Portfolio Changes

As I have not been updating my blog for such a long time, readers would naturally be curious as to how my portfolio has changed. My philosophy remains the same as it has been before - I would even venture to say that it has even strengthened further over the years as I learn more and cultivate a stronger, more consistent mindset for value investing. Some friends whom I have been communicating with regularly in the investment blogosphere even think I am rather "staunch" as I strictly believe in a "no speculation" policy, refusing to do any short-term trades and also staying away from crypto-currencies (the current "hot" fad") and lottery (yes, including the recent World Cup, where I did not place a single bet). I guess I believe in being disciplined over the small stuff, so that I can remain disciplined on the big matters.

In a nutshell, my portfolio has changed quite a bit from my last update as at 31.01.2012. I will be revealing my latest July 2018 portfolio in the next post, but right here I would like to fill the gap by providing a list of what I had divested, along with reasons and with a summary of profit and loss numbers.

Below is a table showcasing each position, the divestment date and price, dividend received, adjusted gains/losses and also CAGR on the position. I had started measuring CAGR for each investment position in order to ascertain if each individual investment decision was made correctly and if it would yield a decent return. This would also be displayed in my first portfolio showcase since I stopped blogging, but subsequently will only be updated on an annual basis.

Explanations for the three divestments are as detailed below:-

SIA Engineering ("SIAEC") - A starting position was taken in this blue chip, large-cap company in 2010, with additional positions taken in 2011 to average down on the position. The original thesis can be found in the older posts within my blog and thus I will not repeat myself again. The position was divested in 2014 when the Company reported weaker earnings, and also lower cash flows from JV and associates. I did not merely act on one quarter's results, as this could have been a one-off event and an aberration or temporary phenomenon. A second quarter of weak results and also commentary from industry reports confirmed my suspicions though - aeroplane engines were becoming more efficient and newer models needed less checks, and checks may not have to be so comprehensive. This meant that the cycle for checks would lengthen, and this would have an impact on SIAEC's earnings and cash flows. In addition, there was also more competition as MRO players started to expand and muscle into SIAEC's turf and territory. These two phenomena were structural changes occurring within the MRO industry and did not seem like temporary cyclical headwinds. Hence, the decision was made to exit the position.

Including dividends received over the 3-4 years, a total gain of +38.4% was made on this position which represented a CAGR of 9.6% over the period of time I was vested.

MTQ Corporation - This can be considered a very "old" position as it was first taken in 2009. MTQ is an oil and gas services company which is servicing blow-out preventers from the oil and gas industry. It also has an Engine Systems division which supplies engines and turbochargers to the motoring industry. This position was divested in August 2015 as MTQ was severely affected by the downturn in the oil and gas industry when oil prices crashed from around USD 150/bbl to USD 20-25/bbl (at the nadir). Though the Company had good FCF and also a strong Balance Sheet, the downturn was very sharp and looked to be protracted, and their cost base was apparently too high to be able to sustain profitability. During good times, during my visits with Management at AGMs, it was mentioned that the Company could get orders and still be profitable if oil prices fell to USD 40. In hindsight, that was probably too optimistic a projection as the reality was that even when oil prices are hovering at USD 60/bbl, the Company is still making losses. Compounding the problem was also the purchase of Binder in Indonesia just before the oil price crash, and this proved to be a drag for Management. MTQ eventually sold off their Engine Systems division (something which I was lobbying for during many an AGM), but they still needed to announce a 2-for-5 rights issue at 20 cents/share to beef up their Balance Sheet. There were also free detachable warrants of 1 warrant for every 4 rights shares at an exercise price of $0.22/share as a method to potential raise more money for the Company. Needless to say, this corporate move was dilutive to earnings per share and the warrants would have also significantly increase the issued share capital base if fully exercised.

My action to divest MTQ was already considered belated, as I read the (bad) news on the sector at the time with growing consternation without taking any action, mistakenly thinking that the Company I invested in would be somewhat immune or protected from the troubles plaguing the industry. In hindsight, I was probably wrapped up in a cocoon of invulnerability and failed to see that the Company I owned was just another player suffering from the growing malaise afflicting the oil and gas industry. Lesson learnt here - don't be complacent and also don't behave like a rabbit caught in the headlights - freezing and not doing anything is not going to help when the business world is dynamic and ever-changing.

Fortunately, I managed to divest MTQ at a profit despite the thumb-sucking, netting a total gain of 52.8% after dividends which worked out to be a CAGR of around 8.64% over my holding period.

The Hour Glass - This one deserves a post on its own, and it will be detailed in a subsequent post as to the rationale for making the investment; as well as the reasons for the eventual divestment and recognition of the loss. This investment unfortunately generated a return of negative 8.35% over the holding period. The key, of course, is to learn from the mistakes and avoid a repeat of his sad situation.

Whatsapp Chat Groups - Boon and Bane

To end off this post, I would like to state a major difference between the way I was communicating prior to stopping the blog, versus currently. I started using Whatsapp to create chat groups for investment some time around 2015, and it has been both a boon and a bane, I would think. A boon in that it is now much easier to communicate ideas on investments to like-minded people, and also to receive interesting ideas with which I can act upon and do more intensive due diligence. The bane is when there is a lot of noise generated, short-term thinking along with a trading mentality (yes, stocks as inventory rather than assets) and also the problem with "Group-think" (which is much more pervasive than I had ever imagined).

So, sometimes it is better to distance yourself from groups and just have some quiet time to think over investment theses and ideas, and to make sure that the logic and reasoning and both sound and defensible. This is not to say that I eschew the idea of using chatgroups, it is just that I feel there are limits to sharing deep due diligence ideas through a chat platform (not efficient for typing and also somewhat too informal) and also that people do not tend to provide constructive criticism whenever I say something, probably either because they do not want to antagonize me or that they had not read deeply enough into a Company to be able to comment. I will probably say more on this in due course but will just end off here for now.

Divestment of Tat Hong – Analysis and Lessons Learnt

My previous post on Tat Hong’s 1H FY 2011 results ended on a pessimistic note, as I had mentioned that I will be keenly monitoring the Company’s 3Q FY 2011 results to review margins, revenues, utilization rates and overall profitability and cash flow generation. Well, the jury is out – Tat Hong released its 3Q FY 2011 financial statements on February 14, 2011; but it was more of a Valentine’s Day nightmare than a gift, for the numbers were quite horrendous by any standards. This post is not just to highlight the numbers and the deterioration of the business, but also serves as a lesson and wake-up call to yours truly (yes, ME) on which companies I should choose to avoid in future when searching for a value investment. Note that this investment in Tat Hong was made back in September 2008, when my criteria for strong Balance Sheets and Free Cash Flow was not as rigorous as in 2009 and 2010.

Just for the record, the divestment was made on February 15, 2011 at a price of S$0.895 per share, and capital gains to be recognized amount to about S$5.2K. Taking into account the holding period of Tat Hong, including dividends and subsequent purchases during the bear market, my annualized gain is about +17% per annum. Admittedly, this could have been much better if I had recognized and heeded the many red flags and warning signals which popped up all over the place, but I chose to stubbornly ignore them and hang on as I felt the positives and economic recovery would kick in and lift earnings and margins. Anyhow, let me go point by point on Tat Hong to dissect the decision to completely divest myself of this investment.

1) Gross Margins – For 3Q 2011, gross margin deteriorated significantly from 38.0% to 34.4%. While this in itself may have been a temporary “blip”, the commentary is chilling in the sense that it casts a pall over the gross margins by stating that lower margins were obtained in crane division (55.6% versus 63.0%) due to more intense competition in local and Malaysian markets (Page 12), and that distribution also saw lower margins of 18.0% versus 19.7% due to strong competition and weak market conditions. Another worrying point was that Tower Crane division in China also contributed to the weaker gross margins due to higher COGS and keen competition, and gross margins fell significantly from 30.1% to just 21.8%. The common theme among these three pieces of negative news was the word “competition”. Note that in the first place, the crane industry is very fragmented; and that even though Tat Hong is one of the major players, there are still many smaller companies that can buy a few cranes and then lease them out, so this makes it a very price-competitive environment. The fact that Tat Hong is succumbing to keen competition signals that this is a permanent problem which is likely to persist, as competition does not just disappear overnight. It is one of the most difficult problems for a company to tackle, and if they did not have a very strong competitive moat in the first place, the first signs of weakness will show up in the gross margins, as what Tat Hong is demonstrating.

2) Finance Costs – Finance costs have been rising steadily, and for 3Q 2011 it went up 25% to S$4.7 million, against just a 1% increase in gross profit. For 9M 2011, finance costs hit S$14 million, up 26% from a year ago. The increase in debt was ostensibly to fund the acquisition of Tutt Bryant, but with the recent massive Queensland floods, it remains to be seen if this will have an adverse impact on Tutt’s operations. The fact is that finance costs are climbing and with a combination of slower revenue growth and lower gross margins, this signals a big red flag.

3) Expenses – Looking at 9M 2011, it is clear that expenses have risen more than revenues or gross profits. Administrative expenses were up 25%, while other operating expenses rose 23%. Apparently, keeping a tight lid on expenses is an effort for the company, as they are hiring for their new subsidiaries in China and also spending more money on upkeep and rental of their machinery in Australia. This has occurred not just in one quarter but I have observed the trend of higher expenses amid lower or flat revenues and earnings, and as a shareholder one should be rightfully worried. Controlling costs should be of utmost importance, and if companies such as Boustead can reduce costs even while growing revenues, then I would expect it of the other companies within my portfolio as well. Tat Hong has certainly not been able to control its expenses effectively, as can be seen in their bottom line performance.

4) Debt Levels – It was always worrying to me that Tat Hong held such high debt, and Management was constantly talking about net debt to equity ratios instead of concentrating on going net cash. I guess this points to a fundamental flaw in my original logic for purchasing Tat Hong – that it is involved in a high capex industry and therefore needed to rely on a lot of bank loans and financing for daily operations. Financial liabilities (ST) increased from S$91.2 million to S$142.9 million, which is a 56.7% increase; while LT financial liabilities increased significantly from S$153.8 million to S$227.7 million (a 48% increase). Total debt therefore increased from S$245 million to S$370 million, and the cash balance of the Company was just S$73.5 million as at Dec 31, 2010.

5) Persistent absence of Free Cash Flows – One of my major gripes was that Tat Hong’s cash flow statement always shows a persistent lack of free cash flows, as cash from operations is seldom sufficient to cover capital expenditures. The result of this, of course, is that Tat Hong has to rely on other sources of funding such as bank loans (as mentioned in point 4), and the recently issued RCPS to AIF Capital. For 3Q 2011, the situation looked even more dire as there was negative operating cash flows of S$15.2 million, while capex was S$12.4 million under “Investing Activities”. Needless to say, most of the cash came from the raising of bank loans (S$43.8 million) once again.

6) Company Characteristics – Tat Hong is a company which is similar in nature to Ezra and Swiber, in that there has to be constant high capital expenditure for it to function effectively. The buying and selling of cranes ensures that capex has to remain high, and even to replace old, worn-out cranes and equipment for rental would entail high capex as well. Considering the Company has diverse business operations in Australia and Asia, this means that upkeep and maintenance of this equipment necessitates high expenditures, and this is a characteristic of the Company which must be taken into account. Sadly, when I was analyzing the Company, I focused more on its size, scale and market leadership rather than these more important characteristics, and which resulted in this mistake.

The above points were sufficient to justify the decision to divest, and to deploy the monies at a suitable time and when a suitable investment-grade company can be identified. I will strive to actively avoid making the same mistakes, and focus a lot more on debt and free cash flows in future analysis of purchases. In fact, this had started with the purchase of MTQ, and then moved on to GRP, Kingsmen Creatives and lastly SIA Engineering. Thus far, their businesses have been more resilient as compared to Tat Hong, even in the face of an uncertain economic climate.

This divestment and change in my portfolio will be reflected in my month-end portfolio review. With the divestment of Tat Hong, it also means I lose an income stream which amounted to about $500 a year (assuming last year’s dividend history), and at a dividend yield of 2.9% (yes, nothing to shout about). Note that the cash will be kept in a bank account until suitable opportunities can be found to deploy it. There will be no rush to invest in a company until ALL the factors are in my favour, and if I have the requisite margin of safety. Capital preservation remains the cornerstone of my investing philosophy.

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.

Ezra – Full Divestment, Rationale and Lessons Learnt

This was not supposed to be such a quick follow-up post to my just concluded Analysis of Ezra’s FY 2009 financials, but certain corporate actions made by the company necessitated my immediate action and attention and which compelled me to act.

Securing of US$1 Billion Chim Sao FPSO Project by EOC

Immediately after my posting on Wednesday morning October 21, 2009 of Part 2 of my analysis and rationale for partial divestment, Ezra dropped a bombshell by announcing that its 48.5% associated company EOC had clinched the much talked-about Chim Sao FPSO deal, which was worth US$527 million for the first 6 years and US$477 million assuming an option is exercised to continue for another 6 years. Thus, the total value of the contract is US$1,004 million over 12 years, or if smoothed out equally, will represent revenues (not profits) of about US$83.7 million per year. The worrying aspect of this announcement is how EOC are going to fund the conversion of a deadweight tonne oil tanker into an FPSO as they are already very highly geared (2.31x as at August 31, 2009). It immediately became clear to me that EOC (through Ezra) would have to do some fund-raising to be able to take on this project, and I was proven right (see next section on Issuance of Convertible Bonds).

Note that although the press releases from Ezra and EOC both tout the value of the contract and talk about stable revenue contributions and asset utilization for at least the next 6 years, I actually analysed the situation and came up with a different perspective:-

1) Assuming additional revenues of US$83.7 million per year, and assuming a very healthy net margin of 20% (gross margin for Offshore Support Services is 38% as at August 31, 2009, so 20% is reasonable to assume for net margin, albeit a little optimistic), this means an additional US$16.74 million worth of profits accruing to EOC each year. Since Ezra owns only 48.5% of EOC, this means they only recognize an additional US$8.12 million per year on a Group basis. This only constitutes about 11.6% of their core FY 2009 net profit, and thus cannot be considered very significant. This is because of the risks to be factored in when taking on a project of such massive size (see point 2).

2) The first FPSO deal clinched by Ezra and announced in 2006 experienced many delays and hiccups as first gas took very long to achieve, and in fact it was only today (October 22, 2009) that Ezra announced that the client had commissioned and accepted the FPSO, with almost a year of delay between deployment to production of first gas. Originally, it was announced that Lewek Arunothai would contribute to 1Q 2009 revenues; but this has since been pushed back all the way to 1Q 2010. This demonstrates the technical difficulty of operating an FPSO, and for the Chim Sao Project the complexity may again lead to delays of a similar nature.

3) Note that EOC mentions that the FPSO would be owned by “4 entities”, though it does not give details of these entities and whether they are part of Ezra Group. Assuming that the entities are external parties, this may imply that EOC may only share up to 25% of the revenues accruing from the FPSO. This makes Point 1 assumptions drop by 75% to just about US$2 million accruing to Ezra Group per year.

4) The EOC announcement also mentions that EOC and a Vietnamese partner will be operating the FPSO, which essentially means the risks are borne by EOC in terms of operational capabilities and execution. Note that a delay similar to the one experienced by Lewek Arunothai could result in additional costs and damages should the client decide to pursue legal action (which I assumed did not happen, but one cannot assume the same for Chim Sao Project).

Viewed from this perspective, it would appear that the deal may not be as lucrative as envisaged, especially if it comes from the angle that the revenues accrued to Ezra Group may not be significant (pending more clarity on the 4 entities and shareholding structure for the new FPSO), but that EOC is taking on a large portion of the costs and risks relating to the financing and operation of the FPSO. There is also concern from yours truly on EOC’s ability to finance an FPSO since its gearing was so high, and I was frankly very surprised that they clinched the deal, as during the EGM I had brought up the point to Management that I did not think EOC would be able to handle the second FPSO as it was highly geared (they did not give me a reply on this).

Issuance of 5-Year 4% Convertible Bonds Worth US$100 Million

As predicted, Ezra announced on the morning of October 22, 2009 that it would be issuing (through DBS), 5-year 4% convertible bonds worth US$100 million, presumably to fund the FPSO as well as for expansion and general working capital purposes. The details can be found in the release on SGXNet, so please check it out on your own. Effectively, they argued, the convertible bond would lower their gearing when converted (conversion price set at S$2.50 per share) to just 8%, and “strengthen their Balance Sheet”. Perhaps they also forgot to mention that in the case where the bonds are NOT converted, they represent even more debt being piled on to their books (Ezra is now taking up the gearing since EOC is already massively over-leveraged). And even if they are converted, the only reason gearing drops is because the share capital base increases by 55.86 million while debt drops as a result of the conversion. So in effect shareholders have to choose between even more debt (and associated interest expense of 4% per annum) or 8.5% dilution based on the existing issued share capital of 658 million shares.

Personally, I feel that this may not be the last time Ezra heads to the capital markets for fund raising, and it is making me very uncomfortable as to how the Group persistently and consistently raise money through financing activities and not operating activities. Their cash burn rate is basically very high and the Group seems to thrive on issuance of shares and increasing their debt. I had once erroneously assumed that Ezra would be able to achieve stable positive operating cash inflows once they had stopped their fleet expansion and tied up their long-term charters; but it seems that this was not to be. Their relentless focus on expansion by taking on the second FPSO and also the purchase of Ice Maiden confirms that more dilutive fund-raising is on the cards, and probably a lot more debt will be loaded on both EOC and Ezra’s Balance Sheets. This is an unacceptable situation to me as an investor.

Other Pertinent Factors

As mentioned in my last post analysing Ezra’s financials, the receivables level has remained persistently high for the last few quarters which shows that revenues are recognized aggressively, while cash collections have taken a back seat. This is a very alarming trend and may indicate some problems with collection even though, as Ezra states, their clients are reputable multi-national oil companies and oil majors who would (presumably) have no problems in paying on time. As their Energy Services Division was the fastest growing division for FY 2009, and since most of the ballooning in receivables came in during FY 2009; it would be safe to assume that this division had the longest credit terms extended, and it is currently doubtful as to whether these receivables are collectible.

During the EGM, Management had also mentioned that their Vung Tau yard would take a back seat and would be left as a Greenfield project. This was somewhat surprising as my understanding was that Saigon Shipyard was already fully utilized and excess capacity for fabrication contracts could be channelled to the new yard instead. This could imply that there is no urgency to build up their new yard, or there is a lack of funds to develop this yard further without once again tapping the secondary market.

Ezra’s Business Model – High Revenue and Profit Growth at the expense of Positive Operating Cash Inflows and Balance Sheet Strength

Ezra’s business model is inherently as described in the title above – boasting high CAGR growth in revenues and profits but most of the time neglecting their Balance Sheet and Cash Flows. Frankly, this had not changed since FY 2005 when they conducted their sale-and-leaseback transactions to free up cash and quickly expand their fleet, and they are now finding ways to get cash from the markets and from loans once again. The old-fashioned method of funding growth through recurring operating cash inflows seems to have been forgotten in their relentless quest to secure higher profits and revenues. This is an untenable situation for me as an investor and my original rationale for investing in Ezra (with the flawed assumption that it would cease aggressive asset buildup and instead build up a war chest of cash) is now gone.

Full Divestment and Lessons Learnt

As a result of the explanations above, and coupled with the discomfort I felt during the EGM, I have fully divested my position in Ezra today at a price of S$2.05, booking a gain of 226% of the remaining portion of my stake (the previous batch was sold at S$2.01 on October 16, 2009). The total realized gain on divestment of Ezra is around 222% for my entire stake, and taken over 4 years this amounts to approximately 55.6% per annum. This will be fully reflected in my month-end October 2009 portfolio review.

Notwithstanding the fact that I had booked a gain on the divestment of Ezra, I will still classify Ezra as an investment mistake and model “case study” on the type of companies to avoid investing in; due to the fact that such an aggressive model does not constitute a prudent value investment and also the fact that leverage is so high (blended gearing of EOC + Ezra) makes this a very risky investment whether during good times or bad. There is much to learn as I mull over my efforts and analysis over the last four years; including analysing all quarterly reports, reading all Annual Reports, attending all AGM/EGM and speaking to key Executives of the Company. Another minor point I would like to bring up is also of the “marketing” and “glossy” nature of the press releases churned out by the Company, similar to those which I mentioned for Swiber (which I had divested in August 2009). A lot of the positives and optimism has been factored into Ezra’s share price at this point in time, and it is trading at a dangerously high valuation considering there are so many risks in execution and also with a weak Balance Sheet and Cash Flows.

As a result of what I had learnt, it would seem that I had been speculating rather than investing as my original premise for investment was itself flawed. In short, I was mistaking myself to be investing when actually my grounds for investing did not conform to value investing principles. For this, I am regretful and will endeavour to learn from this mistake and avoid repeating it when analysing future companies for investment. More focus will be placed on Balance Sheet strength, net cash position and recurrent operating cash inflows instead of just Profit and Loss and margin numbers.

Acknowledgements

I would like to express my gratitude to Donmihaihai and d.o.g. (initials for “Disciple of Graham”) for highlighting salient aspects of Ezra’s Balance Sheet and Cash Flows to me and which helped to complement my own research into Ezra. Donmihaihai’s post on Ezra can be found here, while d.o.g.’s take on Ezra is detailed in this link, in which I had also contributed my thoughts, views and opinions. I humbly accept constructive criticism for making this post, but be warned that any post which constitutes troll behaviour will be immediately and irrevocably deleted without further warning.

Disclaimer: All views expressed above are personal and do not constitute a recommendation to either buy or sell shares of Ezra. I will not be held responsible for any actions relating to the profits or losses made as a result of relying on this blog post. Note that such decisions involve hard-earned money and should not be taken lightly or frivolously.

Can we afford to make mistakes in investing?

Mistakes in life are one aspect of life which no one likes to talk about, and perhaps the one thing you don’t know well about your friends (and even your loved one) as most people are embarrassed to admit their faults. But it’s a fact of life that as human beings, we are fallible and less than perfect. We frequently make mistakes and it is a natural process of evolution that mankind learns from mistakes and avoid repeating them, or else repeats them to his own detriment. There is of course a saying that “History always repeats itself”, but in the world of investing, if history repeats itself too often with respect to mistakes, then one will end up a lot poorer.

The big question I have posed is: can we afford to make mistakes and yet come out better from the experience? How many mistakes are investors “allowed” to make before one is made significantly poorer, or significantly wiser? I think the answer to this depends on the nature and severity of the mistake made, and how much of one’s capital was staked on that particular investment in question. Giving a recent example of mine: my investment in Swiber turned out to be a mistake due to the way the Company was managing its cash flows and also to the fact that its debt levels were too high – but fortunately due to sufficient margin of safety I avoided losses and even managed to book a small gain when I divested my shares. So the idea here is to keep your losses small and manageable by adopting proper techniques to determine margin of safety, and never over-paying for any investment.

Making mistakes in investing is unavoidable, but it is the lessons we learn which are the most valuable. I personally feel that making a small number of minor mistakes is actually good for an investor as it tempers his ego, allows him to learn more about investing (as well as himself) and makes one more determined not to repeat the mistake. Of course, this is based on the assumption that one can be totally honest with oneself and admit that “it was my fault”, and not blame it on everything else like your broker, your friend who gave you the tip, the weather, Ben Bernanke and a host of other unrelated events. It is pretty easy to shift blame but ultimately one has to answer for one’s own actions as it is your money and no one else’s at stake here.

Another seldom mentioned aspect of making mistakes is the length of time required to recognize a mistake. For my Swiber investment, it took 2.5 years for me to fully appreciate the gravity of the situation and make a swift exit, but there is an opportunity cost attached to the time involved and one can argue that the money could have been deployed elsewhere to generate higher returns (on hindsight, of course). The fact that growth companies like Swiber do not give out dividends further compounds the problem of opportunity cost as there is nil return at all during the period of being a shareholder. Even if an investment were to pay say 3% dividend yield but turn out to be a mistake, one can argue that one can easily achieve a 5% or more yield investing in a variety of blue chips which offer more safety and stability. But all this is paper talk until executed; so as an investor we must learn to balance such viewpoints against the practicality of getting such returns over an extended period of time, which brings me to my next point.

An investor cannot afford to make too many mistakes of a much longer duration, as arguably there are not many chances for him to be vested for 10-15 years and observe many business cycles before realizing he has made a mistake. One’s life span is finite and full business cycles can last for 10-20 years; so one should avoid mistakes which only crystallize after a long period of time, during which the hapless investor either earns a paltry return or a very sub-par one (as compared to returns generated from an index fund, for example). So, in such cases, I would advise that investors avoid making such mistakes but instead read more books and learn from Other People’s Mistakes instead ! By distilling their experience and knowledge, one can learn from them without committing the same cardinals sins and at the same time, saving oneself 10-15 years of anguish and mental stress due to an under-performing investment.

So the answer to the topic will be: yes we can afford to make small mistakes, which is good for our ego and temperament as it keeps us grounded and rooted in reality instead of getting carried away by exuberance; but when it comes to major mistakes or those which take a long time to manifest, it is much better to learn from others’ instead of committing them yourself.

Swiber – Reasons and Rationale for Divestment

With the announcement on August 27, 2009 of Swiber’s issuance of a convertible bond (CB) of up to about US$78 million, with up-size option to raise a further US$22 million, I realized immediately that the Company’s cash position was in jeopardy and that my investment in the Company was becoming increasingly risky, which translated into an untenable situation of which I had to take action.

The terms of the CB are for a conversion price of S$1.20 per share, with the condition that the conversion price can be adjusted DOWN to S$1.08 if the average price falls below 90% of S$0.96 in the preceding 20 days prior to issue date. The conversion price reset can go as low as S$0.864, which means with each revision downwards in the conversion price, the potential dilution factor becomes ever larger. Total new shares converted without up-size option is 93.6 million, representing 18.5% of existing share capital of 507.76 million shares, and this can potentially increase with either the upside option being exercised or the revision in the conversion price. A dilution factor of 18.5% alone is already massive, but with the possibility of further dilution then I must say this is a bad deal for existing shareholders. Add to that the interest rate of 5% per annum payable semi-annually – this will increase their finance costs and reduce cash flows further for another 5 years. The worst part of the deal is that the funds are to be used for “working capital and general corporate requirements”, thus implying that there is no exact purpose for the fund raising (not for vessel fleet expansion, or for pre-emptive opportunities).

Considering that a share placement of about US$49 million was done (at 88 cents per share) just in June 2009, it is disappointing and highly suspicious as to why Management had decided to raise funds for a second time in less than 3 months. One of the immediate reasons which comes to mind is that the Company has cash flow problems and that their operating cash inflows are not enough to support both fleet expansion, working capital requirements and to pay interest on existing borrowings. This puts the situation in a whole new light and the issuance of this CB is (to me) an obvious sign of cash flow strain for Swiber, even though they had clearly and explicitly communicated just 6 months ago that they had enough cash raised from bank loans, internal funds and sale and leaseback transactions.

Other pertinent reasons relating to the divestment decision are as follows (in no particular order of significance):-

1) Depressed gross margins as reflected in the Income Statement. This had been going on for more than a few quarters and gross margin has been on a steady decline since 2007. The first few reasons given was that their vessel fleet was not ready and so many third-party subcontracting costs were incurred, thus bumping up their COGS and reducing gross margin. Then, the shocking announcement was made for 4Q 2008 financials that they had incurred a gross loss for that quarter, based on the same reasons as given and because their vessels (originally scheduled for delivery), had not been delivered in a timely fashion. Then, for 2Q 2009, they revealed that they had spent US$23.6 million on fabrication costs (relating to sub-contractors) compared to just US$10.6 million (a more than 100% increase) which pushed down gross margin; and this is even though their vessels had already been delivered in 1Q 2009. This persistent unpredictability of gross margin and rampant “shocks” do not reflect well on Swiber’s cost control, and my reason for investing is to ensure a certain level of predictability and stability; and not to see gross margins being subjected to a roller-coaster ride.

2) Increase in financing costs as a result of higher gearing will continue to impact both their profit and loss statement as well as their cash flow statement. In addition to new bank loans secured as well as their medium-tern notes, Swiber has now pulled off a CB and this will add to their debt significantly. Gearing is much too high for me to feel comfortable considering that their order book is not growing at a similarly fast pace.

3) US$71.2 million worth of bonds need to be repaid by 3Q 2010, and from their cash flow statement one can see that most of their cash is being generated from financing activities, and not operating activities (refer to my previous post on Swiber’s 1H 2009 financial analysis and review). This clearly shows that operating cash inflows are insufficient to sustain the business and provide working capital, so Management has had to constantly tap the capital markets for funds. With cash balance just hovering at US$59.4 million (as at June 30, 2009), there is sufficient concern that cash balances may be further strained to pay back the bonds, as well as any maturing bank loan facilities.

4) The dilution factor in the two most recent fund-raising activities cannot be simply ignored. The first fund raiser was back in June 2009 with 84 million new shares being issued at S$0.88 per share, diluting existing shareholders by about 20% of the then-issued capital base of 421,355,000 shares. Now, with the issuance of the CB, another potential minimum dilution factor of 18.5% will be applied to all existing shareholders, further reducing EPS ceteris paribus.

5) Contract flow has lessened considerably with the onset of the global financial crisis, and a weak point about Swiber (compared to Ezra’s business model) is that their contracts are of short duration and are not locked in for long periods (unlike Ezra with 3 to 5 year contracts with oil majors). This means that order book is constantly being depleted and has to be replenished quickly in order to keep the top-line healthy and to ensure cash inflows keep coming in. If one had noticed, tender book for Swiber had increased from US$2 billion to US$5 billion to a recently reported US$7 billion for jobs from 2010 to 2015. One must question how much of this tender book can actually translate into order book, as their “hit rate” has not been historically high. So far they only clinched US$80 million for 1Q 2009 and US$93 million for 2Q 2009, this implies that about US$340 million will be clinched for the FY 2009, by extrapolation. Comparing this to their more robust order book back in 2007 when they secured larger contracts of more than US$100 million per contract, this begs the question – if they have a larger fleet size and are able to bid for higher-value projects, then why are the current jobs secured in 1Q and 2Q 2009 smaller than the ones secured back in 2007 and 2008?

6) Many of the recent corporate actions undertaken by Swiber had also hinted to me of their urgent need for cash, as evidenced by the following:-

a. Swiber and ICON Capital to jointly own Swiber Victorious (announced in March 2009). If they had enough funds they would not sell part of their vessel to ICON and cede part of their ownership in this vessel;
b. Divestment of 30% share of OBT in April 2009 for US$3.9 million, at cost instead of at a premium. This had, to me, hinted that they needed cash or they would have negotiated for better terms relating to the divestment;
c. Sale of shares in Perfect Motive in June 2009 for RM 200,000, when the book value of Perfect Motive was RM 324,000. Another loss had been realized on this divestment. No motive or rationale for divestment was provided for both cases.

7) One aspect of Swiber’s business model which confused me was why they had to have so many alliances with regional partners, since they were prepared to grow their own fleet. Theoretically, with one’s own fleet, one should be able to bid for larger projects and contracts on one’s own merit, instead of having to share resources and rely on a partner’s help for their projects. Yet, it is the very nature of larger EPCIC contracts where more than one party is required; hence the total profits simply cannot accrue to one party. This makes me question the market dominance of Swiber, since there are other offshore players which are offering similar services in the region which act as competitors. Since Swiber had tied up with so many regional players since 2007, theoretically this should garner them more contracts, but it did not appear to be so. In fact, if we contrast Ezra’s business model, they are able to clinch contracts on their own with oil majors and national oil companies without relying on “synergistic” relationships as a catalyst. This in itself is an attestation to their brand name and reputation, of which I feel Swiber is lacking.

8) Swiber has also put several initiatives on hold, while others are mere talk or speculation. The first was the wildly hyped up Equatorial Driller, which was touted as an alternative to traditional drillers; but this plan and the entire project was shelved due to the onset of the global financial crisis, leaving the plan in limbo; and no more was said of this since then. The problem was that Swiber had hired a very experienced team of drillers headed by Mr. Glen Olivera, of which they had to pay monthly salaries, and in the end this team ended up with less work than originally intended, as Swiber only has a small drilling project with NuCoastal in Thailand. At the AGM, they clarified that they were selling services relating to drilling in lieu of the postponement of the Equatorial Driller plans, but does that justify the high cost of maintaining an entire drilling team?

9) The other initiative which was talked about in presentation slides was wind energy and wind farms, and how Swiber could technically deploy their vessels to service this new and growing industry. What made me uncomfortable was that Swiber seemed intent of moving out of their comfort zone without even having established a firm foothold in the EPCIC and drilling arena; and the plans sounded lofty and ambitious but without much substance. Ultimately, if something is being discussed and put into presentation slides, one would assume that Management has been working on something concrete but so far Management has not provided updates nor given a progress report on this planned initiative.

As a result of the above, and due to my nagging discomfort with the way the Company is being managed and issues with cash flow and dilution, I have decided to divest the shares of Swiber and have done so at a price of 95.5 cents, crystallizing a gain of 19% on my initial investment. With a holding period of about 2.5 years, this translates to a return of roughly 7% per annum (it will be lower if you factor in compounding). Please note that even though a gain was recognized on this transaction, it is still (and will be) classified as an “investment mistake”* because of the underlying principles behind the decision, which resulted in the move to divest much earlier than I had intended for. The proceeds will now be shifted to an opportunity fund to await deployment once I have identified another suitable investment opportunity. Proper care and due diligence will be exercised to prevent a mistake of a similar nature.

*Note: Every buy and sell decision which I make must be supported by justifications based on factual data and a complete and objective analysis of the facts at hand. There is no room for “falling in love” with a company and hugging its shares for dear life, even when something fundamental has occurred which frustrates my original intention for investing in the Company. This is in line with my investment philosophy of keeping a close watch on the companies which I own, to assess if they begin to diverge from my fundamental investment objective(s).

Disclaimer: The above are merely personal opinions and observations relating to my decision to divest the shares of Swiber Holdings Limited. It is NOT to be taken as an inducement to buy or sell shares in the Company, and I shall not be held responsible for any losses relating to said decisions. Please consult your lawyer, accountant or other qualified professional before undertaking important financial decisions which could have an adverse impact on your wealth.

Pacific Andes - Rationale for Divestment

I sold off my entire stake in Pacific Andes today, capping a three-year long investment which saw one round of capital injection; and which resulted in a significant 38% loss. Even though the Company had announced a decent set of full-year (FY) 2009 results, with net profit attributable to shareholders up 38% to HK$664 million, the nail in the coffin came with the announcement of a fresh rights issue, coming hot on the heels of a previous one in March 2007. The offer this time was a 1-for-1 rights issue at 15 cents per share (a 50% discount to the last closing price of 30.5 cents) with additional warrants attached (1 warrant for every 5 rights shares subscribed for, exercise price 23 cents). The rights were supposed to raise about S$228.6 million while the warrants could potential add another S$70.1 million to the Company's coffers.

So one might ask - why is this the "nail in the coffin" ? Presumably, if I had wanted to increase my stake in PAH, I could have done so at 18 cents back during March 2009, but hesitated from doing so. In fact, a cursory glance at PAH's business model and financials would not leave one surprised as to the timing or magnitude of the rights issue. While I had previously added more PAH back in 2008 at a price of 44 cents, I had failed to take into account the inherent business model flaws which would precipitate a full-scale rights issue, and apparently Management also "forgot" about the massive dilutive impact of such a fund-raising exercise on both earnings and (future) dividends per share. Some of the reasons for my divestment are stated below in point form for easy reading and reference.

1) Paid too high a valuation - This fact was apparent right from March 2006, when I first purchased the company at a high price of 81 cents (pre-rights). It was probably valued at around 8-9x historical PER at the time, and I had neglected the fact that it was in SCM and trading and was a high volume-based business, but more on that later. The rights shares issue back in March 2007 were offered at 52 cents, seemingly a juicy offer since my purchase price was a high 81 cents. In August 2007, I continued to purchase more at 61 cents to further average down my cost. This was till July 2008 when I added my last round of PAH at 44 cents, giving at least 8 good reasons for doing so. Since I could justify my purchase so succinctly, I could also figure out what I had omitted to make this such a glaring error. All my reasons and rationale had not accounted for the Balance Sheet weakness of PAH and its business model which I shall elaborate on later. Taking the FY 2009 net profit of HK$664 million, it's about S$132.8 million. Dividing this by 1.391 billion shares gives an EPS of about 9.54 Singapore cents. At the current price of 35.5 cents, the PER is about 3.72. This may seem undemanding at first but considering the dilutive effects of the rights issue, the share capital base will "expand" to 2.8 billion shares and EPS will be halved. Thus, it does not seem like such a bargain any longer.

2) Holding Company Effect - PAH suffers from this effect which means it derives most of its value from their investment in another company, namely China Fishery Group Limited (CFG), in which I am also vested. It holds a 64.1% stake in CFG and works closely with CFG in its SCM and Trading business. However, PAH itself does not have the hard assets which CFG has. This means that much of its valuation is derived from the valuation of CFG; and CFG is the main downstream revenue generator as it is the Company which catches the fish. Hence, PAH is involved in a very high volume-based business (not unlike Noble or Olam) in which net margins are very thin. In fact, it can be readily observed that PAH has a net margin of less than 10% based on FY 2009 results, while CFG has a net margin of 26% based on 1Q 2009 results.

3) Lack of Tangible Assets limits collateral for loans - The rationale for PAH to raise funds is to provide for working capital needs (see point 4 as well). Notice that the company had NOT managed to secure any funding through bank loans and the CEO commented that it was difficult to do so during this harsh credit crisis. Yet, a quick glance at CFG shows that CFG had recently (in 1Q 2009) obtained a US$60 million bank loan to finance its expansion into the South Pacific Ocean. The reason for this is the lack of tangible assets belonging to PAH which can be used as collateral for loans. Previously, PAH would have used shares in CFG as collateral to banks, but during this severe credit crunch, banks are more cautious when lending and would prefer tangible assets such as fishing vessels and inventory (such as fishmeal) as collateral, all of which are owned by CFG and not PAH.

4) No clear objective for Fund-Raising - Most companies which issue rights have some specific objective in mind. Capitaland and its REITS CCT and CMT raised funds to pay down debts and to act as "pre-emptive" capital for M&A opportunities (or so they claim). Other companies raise funds to (presumably) capture opportunities for expansion and growth as there are many assets out there selling at distressed levels. Such cash is vital for taking advantage of opportunities. PAH only said that the cash was to be used for working capital, which I assumed to be for normal operating expenses and for daily use. This implies that the Company was short on cash for the normal operations of the Company, and did not have a specific objective for the cash, which makes the fund-raising all the more suspicious. It is CFG which has the clear growth strategy, with its elongation of vessels, deployment of vessels to the South Pacific, as well as introduction of ITQ. Therefore, it can be clearly seen that CFG's business model is very different from PAH as it has high net margins, high cash generation ability and has clearer scope for expansion.

5) Lack of Catalysts for Growth - As mentioned before, much of PAH's "growth" can be attributed to its 64.1% stake in CFG; hence its "value" hinges upon the value of CFG. This in itself is a very risky proposition for investment as the Company itself has no objective, clearly-derived value for which one can make a value proposition. Its SCM business can be likened to a commodity business as SCM models are essentially the same, are volume-driven and suffer from thin margins. This fact, coupled with the lack of tangible assets and the Company's excessively high gearing, made for a poor investment choice.

Unfortunately for me, I had to learn from this mistake the hard way - by taking a substantial loss by selling at 34 cents per share. But this mistake actually offers me better insights as to how to value a company, what to avoid, things to watch out for and more facets to consider when assessing if a company is suitable for long-term investment. The cash call was a timely reminder to me that this mistake had been made 3 years ago, and finally the time has come to divest of this mistake before it became a full-blown debacle. The opportunity cost of NOT divesting can sometimes be greater than the actual financial loss from divesting sooner (rather than later). Because of my reluctance to take a larger loss on this earlier (Oct 2008 through March 2009), I also omitted the chances to recycle the cash to other more promising companies like Boustead and Tat Hong. Thus, my mistake is two-fold and I feel mortified.

Moving forward, I will seek out more opportunities to purchase under-valued companies at attractive prices and a decent margin of safety; and will pay special attention to Balance Sheets and business models, as well as the fact that the companies I own are supposed to provide me with money (through dividends) and NOT keep asking me to pump in money instead ! I shall endeavour to pick myself up from this mistake, dust myself off and move on. I treat this as a good (though painful) learning experience, and promise not to make a similar mistake in future.

Note: This realized loss will be reflected in my May 2009 portfolio review as an offset against realized gains (currently standing at S$12.8K) and I shall cease all coverage of Pacific Andes from now on. Readers can access archives for PAH but all further updates shall be confined to CFG (which I still own).

When the going gets tough, the tough get....going ?

Investors who have stayed with my blog for the entire duration of the bear market (yes, 16 months so far) and have been invested fully throughout will probably be wondering if there is ever any light at the end of the tunnel ! The fact is that market conditions are always dictated by Mr. Market and he follows economic cycles to determine his mood swings, and whether he decides to pay a high price or a very low price for a business. As investors, our job is to evaluate the underlying business and not pay too high a price for it, in order to maintain margin of safety. The bear market and sharp recession has challenged my notion of margin of safety and also afforded me some insights into my investment choices, some of which I would admit to be mistakes which could have been either avoided or mitigated. When the going gets tough, frankly usually the tough get going (i.e. exit the market). But I am not about to succumb to Mr. Market's manic mood swings, even though the psychological effects of his swath of destruction have pummelled many an investor (including myself). A back to basics analysis would tell one if holding on and averaging down is wise; or if one should just cut loss and re-deploy the funds.

A more obvious boo-boo made by yours truly was to purchase companies which leveraged heavily for fast growth. Evidently, this strategy worked well during times of economic expansion and with the availability of easy credit. However, with a severe credit crunch under way and banks being unwilling to lend, these highly leveraged companies became prime candidates for implosion, due to their inability to refinance their short-term debt and also the cash flow burden which they had to bear in the meantime. Companies like Ezra, China Fishery and Swiber which geared up to expand found that the going was very tough over the last 6 months, to the extent that I did perspire quite a bit and went through a few sleepless nights wondering if they could pull through the crisis. Though Ezra and Swiber employed sale and leasebacks, there's no argument that operating lease expenses would still represent a major cash flow drain, while they still have bank loans to service and refinance. China Fishery had to issue senior notes at about 9.25% interest rate (extremely high), and though they are due in 2013, the huge interest expense is eating up valuable cash at an alarming rate. If not for the fact that China Fishery had good net margins and a lot of their debt is collateralized using their own vessels, plants and inventories, I suspect they may face financial problems similar to the ones recently faced by S-Shares.

So it's apparent from the above that my choice of companies with such heavy leverage has been less than exemplary, and my original focus on value investing may have been viewed by some skeptics as little more than a distorted version of Peter Lynch's "Growth Investing"; albeit with high risk ! Since the job of the value investor is to minimize risk in his investments by requiring a good understanding of a business with little or no debt, I am somewhat guilty of violating this rule ! But we live and learn and it's not the end of the world because of these errors of judgement; I take it in stride and will make sure I am more wary of such complex financing schemes and such high leverage when evaluating future potential companies.

With the current bear market reaching new lows in early March 2009, I did take the opportunity to re-balance my portfolio by purchasing more of Tat Hong and Boustead; as they are more established and cash-rich. This has boosted my stake in both companies to levels above that which I own in Ezra and Swiber; and this acts as a buffer in case Ezra and Swiber encounter any critical problems in managing their debt. As for China Fishery, the recently declared bonus issue of 1 for 10 shares will allow me to average down my cost at no extra cash outlay. Just for info, Tat Hong was purchased on March 3, 2009 at 53 cents and Boustead was purchased on March 9, 2009 at 46.5 cents. This has reduced my cost in Tat Hong and Boustead to 68 cents and 55 cents respectively, and will be updated in my month-end portfolio review.

This bear market and unprecendented crisis has taught me a lot about companies, how they operate, risks and valuations. It's a very enriching learning experience though it will probably end up being an expensive one if anything untoward happens to my companies (touch wood !). As we are not out of the woods yet, there is still some potential for trouble though the probability has been greatly reduced since October 2008.

There will be more of such candid admissions in the months to come, and sometimes I feel I could compile my own "mistakes checklist". For readers out there, please feel free to criticize (constructively, please) and give advice. We are all learning as we go along.

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.

Investment Mistakes Part 9 - Selling Too Early

One of the most classic investment mistakes is selling too early, in what is also known as "short-termism". This occurs when one does not take a long-term view of a company, and attempts to "trade" a small gain, or maybe one sets a specific target price which is 10-20% higher than their buy price, and subsequently sells when it hits the trigger point. Both methods are price-dependent, rather than being business-dependent. Again, I reiterate that if you have bought into a good company at a fair price, then why in the world would you want to sell ? So begins my analysis of my mistake below....

Please also note that an investment mistake does NOT necessarily consist of transactions which resulted in losses. In fact, this mistake had resulted in a gain, but the opportunity cost is so tremendous that on hindsight, the paltry gain is hardly enough to justify the act of selling so early ! The company in question is Labroy Marine, which is a prominent ship-building company in Singapore and which had recently also ventured into building rigs. Just today, on October 29, 2007, the company announced that it was being acquired by Dubai Drydocks LLC (DD), the same company which took Pan United Marine private in May 2007. DD is offering S$2.8425 per Labroy share and they are planning to take the company private. The chairman Mr. Tan Boy Tee and executive director Mr. Chan Sew Meng have already agreed to sell their combined 65.49% stake in Labroy to DD, effectively making the deal unconditional.

Way back in April 2005, I purchased shares in Labroy Marine at a cost of 64 cents per share, which looks amazingly cheap now eh ? The problem was that at the time, I had nary a clue about value investing, and even less knowledge about how to properly value a company and see its potential. To me, it was all about making a quick gain from the sale of the shares (I did not use contra) at a set price. In the end, I sold at 70 cents in May 2005 for a miserable gain of 9.4% (6 cents) and totally missed the upside as the company grew and the share price ran into S$1, then surpassing S$2. That was one of the hard lessons I had to learn about the essence of long-term investing, and even Warren Buffett had made the same mistake when he sold his first investment too soon. The painful fact is that if I had held on to Labroy till now (when DD announced the acquisition), I would have made a cool 344% profit.

The mistake and subsequent lesson to be learnt is that one should NEVER set a pre-determined target price to exit if one is investing in a company. This is because a company is always growing and its business is dynamic, thus placing a target price on it (like the analysts always do) seems to imply that the growth will terminate when it hits that price. In the end, one may very well sell for a profit but miss out on the huge potential which the company has to offer.

Since that mistake was made, I have held on very tightly to shares in Ezra Holdings which I purchased in October 2005, as I recognized that the company was growing very rapidly and that its earnings were scaling up tremendously. A mistake was made and a lesson was learnt; Ezra has since grown into a different animal altogether, to the extent of reporting 5 years of consecutive revenue and net profit growth and also listing a subsidiary in Norway. Thus, I now approach every company with the view that I am buying a piece of a good thing, and who wants to let go of a good thing to exchange it for something which may not be so good ?

Investment Mistakes Part 8 – Buying into a company whose business I did not understand

This can be said to be my second-last mistake of commission (thus far), my last probably being Global Voice once I have sold it off. The company in question is United Test & Assembly Centre (UTAC), a semi-conductor chip testing company similar to Stats Chippac and Chartered Semi-conductor. I had purchased UTAC on June 9, 2006 based on a friend’s rough TA guide (not considering fundamental characteristics – another mistake). According to him, he had identified a “support line” for UTAC and I also did some basic preliminary research on the company and found that it had 11 quarters of consecutive earnings and revenue growth. Strangely enough, the price had retreated to my buy price of 77 cents per share even though the prospects of the company seemed very good. It acquired a subsidiary in Thailand which it renamed UTAC Thailand and this helped to boost capacity further, creating economies of scale.

This is the only company in which I have made a profit from after selling but which I still classify as a mistake. This was because the capital gain was made from pure luck and a bull market, rather than based on proper research and fundamental considerations. After the Feb 2007 slump, I subsequently sold UTAC off on February 23, 2007 at 90 cents per share, netting a 15% gain over 8 months. This was about 1.5 weeks after I made my value purchased of Swiber (on Feb 14, 2007) after they secured a record LOI of US$146.6 million from Brunei Shell. It was a process of divesting my speculative companies and concentrating on value investments such as Boustead, Ezra and Swiber.

So what was actually wrong with UTAC, you may ask ? Technically speaking, nothing was “wrong” with the company in the sense that the company was doing fine; but the nagging thing about it was that its revenues and profitability could not be predicted with certainty, as the industry was cyclical and volatile by nature. This led to problems in terms of estimating future earnings and revenue, as the visibility was not present. Though there was a glut of information about the use of DRAM and about Korea’s Hynix expanding (plus a thousand and one other little bits and pieces of “related” information), this still did not help to accurately portray a picture of confidence for the company. This is one reason why the companies I invest in have a sustainable order book and good earnings visibility in the next 2-3 years (something different from the way Buffett invests, as he looks for companies with strong franchises and wide economic moats). More on this method in a future posting.

Besides the fact that the industry was competitive, margins were thin and future demand was uncertain, there was also the problem of complicated jargon relating to the semi-conductor industry which got me all boggled ! In UTAC’s quarterly review, there were a lot of technical terms used for various aspects of their operations and I was unable to determine the financial impact of these moves as I had limited knowledge and understanding of the industry as well as jargon. This caused further problems in trying to decipher what the future prospects of the company were like and whether it would be able to retain a certain competitive edge in future. It turns out that UTAC did not manage to continue their increasing profitability and suffered a drop because of UTAC Thailand’s slower start-up. Eventually, they were bought over for S$1.10 per share.

The lesson to be learnt here is that one should not invest in something which one does not fully understand, and this includes companies which are in fast-paced and ever-changing industries in which future demand and prospects cannot be ascertained confidently. In this way, we invest within our circle of competence and ensure that there are no unpleasant “surprises” which will crop up to cause our investment to stumble. Also, do not forget to buy with a wider margin of safety for investments which you do not 100% understand, in order to build a better safety cushion in case something goes wrong.

Note: This is my last posting on mistakes of commission; future postings on investment mistakes will focus more on mistakes of omission which have resulted in opportunity losses.

Investment Mistakes Part 7 – No consideration for industry characteristics

This mistake is one mistake which many investors frequently make, and it is admittedly one of the more difficult mistakes to analyze, predict and rectify. Being value investors, one is always supposed to analyze the company’s maco-environment including the industry and country where it provides its services or products (e.g. China market, local market or international market). Early on in my investing career, I had frequently failed to adequately consider these factors in my analysis, resulting in “shocks” and lost money.

I had purchased a company called C&O Pharmaceutical on February 28, 2006 at a price of S$0.405 per share. This was a China-based pharmaceutical company and at the time, they had just acquired another company called Shenzhen Liancheng in order to boost their distribution network and bolster their pipeline of available drugs to sell to the market. Their market was predominantly China and the pharmaceutical industry (at the time) was loosely regulated, meaning suppliers of drugs did not have to pass their drugs through intense scrutiny and draconian checks in order to be commercially saleable. Also, loose regulations meant that prices for drugs could also be “fixed” and many companies freely bumped up the prices of their drugs in order to secure a large gross margin. In short, the lack of regulation meant that a lot of drugs were being pushes to the market irregardless of their safety (or even intended) effects, and that prices were wildly out of proportion with international standards (even if the drugs were supposed to have the same effects).

The company in question was doing well at the time; the purchase of Shenzhen Liancheng meant that they would increase their pipeline of ready-to-market drugs and also enable “better control and greater effectiveness” in the distribution of third-party and C&O branded drugs. To be honest, I also did not do an in-depth research of the company or its industry and I based most of my purchase decision on this one piece of news (another mistake !).

In June 2006, after a series of drug scandals in China, the Chinese government announced a clampdown and tightening of the entire industry by imposing price ceilings for various drugs and also subjecting new drugs to greater scrutiny. This had the unexpected effect of compressing margins for all Chinese pharmaceutical players and overnight, many local-listed China pharmaceutical stocks (e.g. Landwind Medical, Reyoung pharmaceutical, C&O and Asiapharm) suffered. Looking back, I should have been able to anticipate such moves by the government as there was already rampant and uncontrolled drug distribution and pricing by unscrupulous drug companies. It was only a matter of time before such stringent regulations came into effect, as China wished to preserve its reputation in light of the upcoming 2008 Beijing Olympic Games.

Thus, on November 9, 2006, I sold out at a 36% loss (at S$0.255) after C&O gave a profit warning (amid a flimsy excuse of lower profits due to the “consolidation of inventories”). It is currently trading at S$0.48 today (only a slight 20% profit from my old purchase price after nearly 1.5 years) due to the continued challenging environment for Chinese pharmaceutical companies.

Note: The current scandals in the papers involving Chinese products should alert the intelligent investor to possible repercussions from the Chinese government, and one should stay alert of such developments as it may affect your investments in China companies, especially those which produce goods for the domestic market in China like shoes (e.g. Hongguo, China Hongxing), frozen foods (e.g. Youcan, Synear) and consumer goods.

Investment Mistakes Part 6 – No Sustainable Competitive Advantage

I purchased Trek 2000 on January 9, 2006 at a lofty (on hindsight, it was darn lofty !) price of 61 cents, after doing a preliminary research on the company. After months of waiting for “true value” to show, I sold out at a loss of 15% (52 cents) on November 13, 2006. Subsequently, as I discovered more about value investing, I realized that key aspects of Trek’s business had eluded me when I did my analysis in the first place, forcing me to admit that I had made a fundamental error. When I discovered that, I bit the bullet and cut my losses. The counter is now trading at 35 cents as of today.

So what went wrong ? First, an introduction to the company. Trek 2000 is a company which manufactured and patented the thumb drive or flash disk, the small storage device which people carry around to transfer and store data. This device is handy and compact, making it a useful accessory for storage of up to 2 GB of data. This device was much preferred to the portable hard drive as the latter is heavy and cumbersome and prone to damage if dropped. A thumb drive, on the other hand, is light, portable and can withstand some degree of external shocks (of course, don’t step on it lah !). Trek 2000 would earn licensing revenues from these devices and it was also into R&D, designing new thumb drives which had biometric features in order to enhance the security features of each drive.

All in all, it sounds like a good business plan since they are the ones who came up with the technology and are thus earning revenues from it. Unfortunately, several factors come into play which severely diminished their ability to compete effectively and to scale up their business. They are as follows:-

a) Commoditization of Thumb Drive – Their flagship product, the thumb drive, was viciously copied in countries like China and sold under other brands’ names. Trek 2000 went on a legal spree to recover damages relating to the other companies’ selling their products, and they won the lawsuit ! Despite this, many copycats still copy the technology and re-brand the products under their own name. Since the lawsuit only covers certain territories, Trek 2000 would have to take expensive legal action in all relevant jurisdictions in order to recover the “damage” to their brand. This is cost-ineffective and puts a large drain on their resources. Thus, brand and product erosion took place which means their product is rapidly being commoditized.

b) Competition – The usual culprit called competition comes in to eat away at market share and margins for Trek 2000. Although the thumb drive commands quite a good market share and pricing, the technology sector usually moves so quickly that one product soon becomes obsolete. This may well be the case for Trek 2000 in the near future, which is why earnings clarity is not present. This was my first “brush” with the technology sector and I had read that for most technology companies, product life cycle from introduction to decline is very short as compared to conventional products such as toasters and ovens. Though thumb drives may seem to be the portable storage device of the future, you never have the certainty that it will be the dominant product and market leader for many years to come.

c) Poor Investor Relations – Trek 2000 was fined S$75,000 for “selective disclosure” of an interview with Reuters which was not announced through SGXNet. The CEO Mr. Henn Tan personally paid off this fine instead of allowing the company to foot the bill. However, it was not the first gaffe from the company and it shows that they are inept at managing proper disclosure practices.

d) Unable to Maintain Pricing Power for NAND Chips – In Trek’s 1Q 2007 financial review, they said that even though sales volume of their products increased, the prices they commanded were substantially lower. This led to an overall decline in sales revenues and profitability was affected as well. Looking forward, this does not seem to be a temporary “blip” and will probably continue to persist for the company in the long run.

After this experience, I was more careful about choosing companies without wide “moats” around their business to prevent competitors from assailing them. Still, I continued to make errors in judgement (which will be described later on) by choosing to purchase UTAC. Currently, as of this writing, I am also contemplating if Global Voice will become my next investment mistake. Perhaps I should start to write about it now as the feeling is slowly creeping in on me. I hope the numbers from their 1H 2007 financial statements will prove me wrong.